Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
Massive Stock Market Price Reversion May Be Days or Weeks Away - 22nd Sep 19
How Russia Seized Control of the Uranium Market - 22nd Sep 19
Dow Stock Market Trend Forecast Update - 21st Sep 19
Is Stock Market Price Revaluation Event About To Happen? - 21st Sep 19
Gold Leads, Will the Rest Follow? - 21st Sep 19
Are Cowboys Really Dreaming of... Electric Trucks? - 21st Sep 19
Gold among Negative-Yielding Bonds - 20th Sep 19
Panicky Fed Flooding Overnight Markets with Cash - 20th Sep 19
Uber Stock Price Will Crash on November 6 - 20th Sep 19
Semiconductor Stocks Sector Market & Economic Leader - 20th Sep 19
Learning Artificial Intelligence - What is a Neural Network? - 20th Sep 19
Precious Metals Setting Up Another Momentum Base/Bottom - 20th Sep 19
Small Marketing Budget? No Problem! - 20th Sep 19
The Many Forex Trading Opportunities the Fed Day Has Dealt Us - 19th Sep 19
Fed Cuts Interest Rates and Gold Drops. Again - 19th Sep 19
Silver Still Cheap Relative to Gold, Trend Forecast Update Video - 19th Sep 19
Baby Boomers Are the Worst Investors in the World - 19th Sep 19
Your $1,229 FREE Tticket to Elliott Market Analysis & Trading Set-ups - 19th Sep 19
Is The Stock Market Other Shoe About To Drop With Fed News? - 19th Sep 19
Bitcoin Price 2019 Trend Current State - 18th Sep 19
No More Realtors… These Start-ups Will Buy Your House in Less than 20 Days - 18th Sep 19
Gold Bugs And Manipulation Theorists Unite – Another “Manipulation” Indictment - 18th Sep 19
Central Bankers' Desperate Grab for Power - 18th Sep 19
Oil Shock! Will War Drums, Inflation Fears Ignite Gold and Silver Markets? - 18th Sep 19
Importance Of Internal Rate Of Return For A Business - 18th Sep 19
Gold Bull Market Ultimate Upside Target - 17th Sep 19
Gold Spikes on the Saudi Oil Attacks: Can It Last? - 17th Sep 19
Stock Market VIX To Begin A New Uptrend and What it Means - 17th Sep 19
Philippines, China and US: Joint Exploration Vs Rearmament and Nuclear Weapons - 17th Sep 19
What Are The Real Upside Targets For Crude Oil Price Post Drone Attack? - 17th Sep 19
Curse of Technology Weapons - 17th Sep 19
Media Hypes Recession Whilst Trump Proposes a Tax on Savings - 17th Sep 19
Understanding Ways To Stretch Your Investments Further - 17th Sep 19
Trading Natural Gas As The Season Changes - 16th Sep 19
Cameco Crash, Uranium Sector Won’t Catch a break - 16th Sep 19
These Indicators Point to an Early 2020 Economic Downturn - 16th Sep 19
Gold When Global Insanity Prevails - 16th Sep 19
Stock Market Looking Toppy - 16th Sep 19
Is the Stocks Bull Market Nearing an End? - 16th Sep 19
US Stock Market Indexes Continue to Rally Within A Defined Range - 16th Sep 19
What If Gold Is NOT In A New Bull Market? - 16th Sep 19
A History Lesson For Pundits Who Don’t Believe Stocks Are Overvalued - 16th Sep 19
The Disconnect Between Millennials and Real Estate - 16th Sep 19
Tech Giants Will Crash in the Next Stock Market Downturn - 15th Sep 19
Will Draghi’s Swan Song Revive the Eurozone? And Gold? - 15th Sep 19
The Race to Depreciate Fiat Currencies Is Accelerating - 15th Sep 19
Can Crypto casino beat Hybrid casino - 15th Sep 19
British Pound GBP vs Brexit Chaos Timeline - 14th Sep 19
Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - 14th Sep 19
War Gaming the US-China Trade War - 14th Sep 19
Buying a Budgie, Parakeet for the First Time from a Pet Shop - Jollyes UK - 14th Sep 19
Crude Oil Price Setting Up For A Downside Price Rotation - 13th Sep 19
A “Looming” Recession Is a Gold Golden Opportunity - 13th Sep 19
Is 2019 Similar to 2007? What Does It Mean For Gold? - 13th Sep 19
How Did the Philippines Establish Itself as a World Leader in Call Centre Outsourcing? - 13th Sep 19
UK General Election Forecast 2019 - Betting Market Odds - 13th Sep 19
Energy Sector Reaches Key Low Point – Start Looking For The Next Move - 13th Sep 19
Weakening Shale Productivity "VERY Bullish" For Oil Prices - 13th Sep 19
Stock Market Dow to 38,000 by 2022 - 13th Sep 19 - readtheticker
Gold under NIRP? | Negative Interest Rates vs Bullion - 12th Sep 19
Land Rover Discovery Sport Brake Pads and Discs's Replace, Dealer Check and Cost - 12th Sep 19
Stock Market Crash Black Swan Event Set Up Sept 12th? - 12th Sep 19
Increased Pension Liabilities During the Coming Stock Market Crash - 12th Sep 19
Gold at Support: the Upcoming Move - 12th Sep 19
Precious Metals, US Dollar, Stocks – How It All Relates – Part II - 12th Sep 19

Market Oracle FREE Newsletter

Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Investment Portfolio Risk Matching Strategy

InvestorEducation / Risk Analysis Oct 31, 2008 - 09:45 AM GMT

By: Richard_Shaw

InvestorEducation

Diamond Rated - Best Financial Markets Analysis ArticleWhether we are coaching you as you manage your assets, or whether we are managing assets for you, if your investment account is mature, we follow this general approach — appropriately tweaked to your specific process preferences and needs.

A mature account is one for which expected new money additions are minimal compared to the size of the accumulated assets — where replacement of lost assets is not a practical or feasible option.


The approach also works well for non-mature accounts, but the “matching” issues may not be currently a necessary management issue.

THE BASIC IDEA

Your investment portfolio is not only about pursuit of returns; it is also about risk management.

Matching investment assets with capital expenditure needs, and matching investment cash flows with needed spending from investments are among the most important aspects of portfolio risk management.

1.    Maturity matching: You should seek a portfolio that has maturities and ready liquidity at predictable values at predictable times to fund your portfolio dependent expected capital expenditures (capital budget).

2.    Cash flow matching: You should seek a portfolio that will provide sufficient cash flow to fund your expected spending (cash flow budget).

If your investment cash flow cannot be sufficient to fund your spending, then the difference should be treated as an annual capital item handled by maturity matching under the capital budget.

3.    Risk Limits: All the while, you need to be assured that you are being adequately compensated by cash flows and expected capital gains for the volatility and permanent capital loss risks you assume.

4.    Asset Allocation: Your asset class selection and class target weights should be consistent with your capital budget, your cash flow budget, and your risk limits.

5.    Process Management: The asset classes, target allocations and the securities selected to represent each class should be managed by a process that maintains the appropriate relationships between the capital budget, cash flow budget and risk limits (collectively, the management parameters).

MATURITY MATCHING

You have certain known or potential capital expenditure goals and obligations that can be estimated as to amount and timing.

If you have significantly more assets than required to meet your ultimate goals and obligations, you may be able to assume high levels of risk with all of your assets to pursue gains.

If you don't have assets that substantially exceed your future needs, or if you simply want to conservatively manage what you have for whatever reason, these guidelines should be applied:

1.    Obligations due within 1 year should be funded with money market assets.

2.    Obligations due from 1 to 10 years should be funded with bonds in the same amounts as the obligations, and with average durations that match, or at least approximate, the timing of those obligations.

3.    Obligations due in more than 10 years may be funded with fixed income assets or with assets with greater potential for capital appreciation, such as common stocks or certain other non-fixed income assets.

CASH FLOW MATCHING

To the extent possible, the asset classes and the securities within the classes should be selected and weighted to provide investment income that at least matches the non-capital spending budget.

While capital spending is handled by matching with asset maturities, operational spending should be dealt with through investment income to the extent reasonably possible and consistent with risk limits.

Operational spending that cannot be covered by investment cash flow should be projected and treated as a scheduled capital expense with matching asset maturities.

RISK LIMITS

A balance between growth potential and loss potential is essential.

The more mature the asset pool (the less ability to replace assets with future earnings) the more the balance should lean toward conservation and sustainability — reducing loss potential at the expense of growth potential.

The less mature the asset pool (the more the ability to replace assets with future earnings), the more the balance should lean toward potential growth with the associated assumption of more risk.

The risk budget should take into consideration at least:

  • market risk (volatility, liquidity and valuation)
  • credit risk (quality, duration and interest rates)
  • inflation risk
  • currency risk
  • geopolitical risk
  • issue selection risk.

ASSET ALLOCATION

The classes in the portfolio should, to the extent possible, have low correlation of returns.

About 90% or more of portfolio return is generated by asset class selection and weights.  Only about 10% or less of long-term return is generated by security selection.  Therefore, time and effort is most effectively used concentrating on asset classes.

Asset classes should be considered in terms of long-term and short-term history, current market conditions, and expectations for future markets that will not be precisely like past markets. Substantial discussion of how and why classes may perform differently in the future is essential.

To prevent a single class from overwhelming the portfolio returns, the maximum weight should be 25% per class.

To assure that a single class has the potential to contribute meaningfully to portfolio returns; the minimum weight should be 5% per class.

To minimize exposure to security issue selection risk, no active management fund or non-core index fund should have a weight more than 5% (core, broad market index funds may be weighted to the extent of the asset class weight).  No individual stock or bond should be weighted more than 1.5 to 2%.

The overall asset allocation plan should include a set of allocation policy target weights (target weights) for each class.  A collar of minimum and maximum weights should accompany the target weights.  That provides some short-term flexibility around long-term allocations.

We prefer to sub-divide asset classes into these three categories:

  • Strategic Core
  • Tactical Emphasis
  • Active Focus.

Each sub-category should be given a minimum and maximum weight within the class.  The result is a two-dimensional matrix of asset classes and asset class sub-categories.   Specific securities are selected to represent each sub-category of each asset class.

It is only necessary to utilize the Strategic Core sub-category to build a perfectly adequate and simple portfolio.  However, a progressively more complex portfolio can be developed by selecting securities for the Tactical Emphasis and/or the Active Focus categories

The Strategic Core should generally be populated with broad, diversified no-load, low expense funds, or ETFs.

Tactical Emphasis is generally populated with narrower no-load funds, ETFs or ETNs that increase the exposure to selected sectors, industries, regions or countries that are included in the broad funds of the Strategic Core.

Active Focus, if not left empty, is generally populated with specialty no-load funds or individual stocks or bonds.

See our prior article on Basic Suitability Issues in Portfolio Design for additional thoughts on appropriate portfolio risk based on “economic age” and financial condition.

BENCHMARKS

A simple benchmark portfolio should be selected against which to measure the management of the actual portfolio.

See our article on practical return measurement issues in portfolios with interim deposits and withdrawals.  Benchmarks don't have “ins” and “outs”, but real world portfolios do.

The benchmark could be as simple as a two class model with US stocks and US bonds (i.e. 60% US stocks and 40% US bonds), or as complex as a single broad index fund for each asset class at the target weight for the class.

See our weekly updated short-term performance tables for 11 different simple two class (US stocks / US bonds) benchmarks.  Long-term performance of different US Stock / US Bond allocations from Vanguard are also provided there.

PROCESS MANAGEMENT

Portfolio design and continuing review should be done in terms of the management parameters (maturity matching, cash flow matching, risk limits, asset classes, target weights and security selection).

Tactical deviation from the allocation target weight within the minimum and maximum range for a class may be considered if supported by clear logic about the relationship between classes or changes in future expectations for the class.

Periodic rebalancing (and optional rebalancing triggered by threshold deviations form assigned weights) should be performed to satisfy the management parameters.

Rebalancing can be pursued more aggressively in a tax-free or tax deferred account due to no wash sale tax consequences of buying and selling securities.

See our article on the need for a tax-loss harvesting security substitution list for taxable accounts.

See our article on wash sale prohibitions with respect to IRAs and related party accounts .

Asset class target weights, minimum weights, and maximum weights should be considered for change no more than annually, but preferably not more often than at 3-year intervals.

Security selection for the Strategic Core holdings should be reviewed at such time as superior alternatives are available, but not more frequently than annually.

Security selection for the Tactical Emphasis holdings should be reviewed annually.

Security selection for the Active Focus holdings should be reviewed quarterly, or earlier on an event driven basis, if necessary.

Advisor and client should confer at least quarterly to review the portfolio — more often if events dictate, or if client prefers more communication.

Among other things, they should consider overall performance versus the benchmark, the performance of specific securities within the portfolio, current and expected market conditions, rebalancing, tax loss harvesting and security substitution, and any other possible needed adjustments or redesign.

Whether you call on us to assist you, or you use other advisors, or you manage your own assets, we recommend you adopt an approach similar to the one we have just described.

By Richard Shaw 
http://www.qvmgroup.com

Richard Shaw leads the QVM team as President of QVM Group. Richard has extensive investment industry experience including serving on the board of directors of two large investment management companies, including Aberdeen Asset Management (listed London Stock Exchange) and as a charter investor and director of Lending Tree ( download short professional profile ). He provides portfolio design and management services to individual and corporate clients. He also edits the QVM investment blog. His writings are generally republished by SeekingAlpha and Reuters and are linked to sites such as Kiplinger and Yahoo Finance and other sites. He is a 1970 graduate of Dartmouth College.

Copyright 2006-2008 by QVM Group LLC All rights reserved.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Do your own due diligence.

Richard Shaw Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules