1. Asset Size
2. Liquidity Needs * Asset Owner Needs: High for banks/insurers (to pay claims/deposits); low for Endowments/Sovereign Wealth Funds. * Asset Class Characteristics: * Liquidity Illusion: Assets may look liquid in normal times but freeze in crises (e.g., Corporate Bonds in 2008). * Stress Testing: Allocations must be tested against “vanished liquidity” scenarios (e.g., 2008 Crisis, 1998 Russian Default) to ensure obligations can be met without fire-selling illiquid assets.
3. Time Horizon * Human Capital (HC): Younger investors have large HC (bond-like) \(\rightarrow\) Can take more equity risk. As HC depletes (aging), financial capital must de-risk. * Liabilities: Pension funds may shorten horizon as the plan becomes “frozen” or fully funded (preparing for termination/buyout), requiring a shift to liability-matching bonds.
4. Regulatory/External * Insurers: Face capital charges (e.g., Solvency II) based on asset risk; encourages high-quality bonds. * Endowments: specific tax rules (e.g., UPMIFA in the US) or spending requirements (e.g., 5% payout for foundations). * Sovereigns: May be restricted from investing in certain foreign assets or strategic industries.
1. Impact of Taxes on Return and Risk Taxes reduce both the expected return and the volatility (government shares the risk). * After-Tax Return (\(R_{at}\)): \[R_{at} = R_{pt}(1 - t)\] * After-Tax Standard Deviation (\(\sigma_{at}\)): \[\sigma_{at} = \sigma_{pt}(1 - t)\] * Note: Correlations generally remain unchanged. * Result: Taxes dampen the risk/return profile. The efficient frontier shifts down (lower return) and to the left (lower volatility).
2. Asset Location (Strategic placement of assets): * Tax-Inefficient Assets (High income/High turnover): Place in Tax-Exempt/Deferred Accounts (e.g., High Yield Bonds, REITs, Active Equity). * Tax-Efficient Assets (Low dividends/Buy-and-Hold): Place in Taxable Accounts (e.g., Index Funds, Tax-Managed Equity).
3. Rebalancing & Taxes: * Rebalancing in taxable accounts triggers Capital Gains Tax (CGT). * Strategy: * Use wider rebalancing corridors for taxable accounts (trade less often). * Rebalance using cash flows (dividends/contributions) rather than selling assets. * Tax Loss Harvesting: Realize losses to offset gains.
Asset allocation is not “set and forget.” It requires revision upon specific triggers:
1. Changes in Goals: * New spending needs (e.g., university building project). * Change in priority (e.g., shifting from wealth accumulation to wealth preservation).
2. Changes in Constraints: * Time Horizon: Approaching retirement or a fixed liability date. * Liquidity: Unexpected cash calls or change in employment status. * Tax Status: Moving jurisdictions or changes in tax law. * Legal/Regulatory: New funding rules for pensions.
3. Changes in Beliefs: * Shift in long-term Capital Market Expectations (CME) (e.g., structural decline in bond yields). * Loss of confidence in active management (shift to passive).
Note: Cyclical market moves (normal volatility) are NOT a reason to change Strategic Asset Allocation (SAA). SAA changes should be driven by structural shifts in the investor or the long-term market environment.
Tactical Asset Allocation (TAA): Deviating from SAA to exploit short-term dislocations.
1. Discretionary TAA: * Based on qualitative judgment (e.g., “The Fed will hike rates, so I’ll underweight bonds”). * Relies on manager skill/intuition. * Risk: Subject to behavioral biases (overconfidence, recency).
2. Systematic TAA: * Based on quantitative signals (e.g., Trend Following, Momentum, Value spreads). * Rules-based; removes emotion. * Example: Moving Average Crossover (Buy when price > 200-day average).
Evaluation: TAA success is measured by the Information Ratio (IR): \[IR = \frac{R_{TAA} - R_{SAA}}{\sigma(R_{TAA} - R_{SAA})}\] * (Active Return / Active Risk).
1. Loss Aversion: * Bias: Pain of loss is 2x the pleasure of gain. Leads to under-risking or panic selling. * Mitigation: Goals-based investing (bucket assets to secure essential needs first); frame risk as “shortfall probability” rather than volatility.
2. Illusion of Control: * Bias: Belief that one can influence outcomes (e.g., over-trading, preference for complex active strategies). * Mitigation: Use the Global Market Portfolio as the baseline; require rigorous justification for deviations.
3. Mental Accounting: * Bias: Treating buckets of money differently (e.g., taking too much risk with “play money”). * Mitigation: Look at the portfolio holistically (Total Balance Sheet approach). However, Goals-Based Investing leverages this bias constructively to encourage savings.
4. Recency / Availability Bias: * Bias: Extrapolating recent events (e.g., buying after a bull run, selling after a crash). * Mitigation: Strict rebalancing rules; formal SAA reviews; Monte Carlo simulation using long-term data (not just recent history).
5. Familiarity / Home Bias: * Bias: Overweighting domestic assets or employer stock. * Mitigation: Global benchmarks; optimization constraints forcing global diversification.
6. Framing Bias: * Bias: Decision affected by how data is presented (e.g., “95% success rate” vs. “5% failure rate”). * Mitigation: Present data in multiple formats (Volatility, VaR, Probability of Success, Stress Tests).