What I am going to write here is half of my summary of how Asset Allocation is done. Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.
Good asset allocation, and financial planning generally, focuses on two main questions:
- When will the cash be needed for expenses?
- What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed? Also, how likely are those returns?
Tonight I am writing about the first question. For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place. (The same applies to financial institutions, though for institutions with short-term funding profiles, you won’t typically use actuaries, not that you couldn’t.)
For individuals and families, the issues come down to needs, wants, dreams, and risks. As for risks, you can look at the earliest series at my blog, [summary here] which was on personal finance. (I never intended to write much on personal finance, and so that was a summary set to get my main ideas out.)
Then comes the hierarchy of expense: needs, wants, and dreams. Aim to satisfy each one successively. Some people can only afford needs, others can get to wants, and a few others can get to dreams. Now, that’s an oversimplification, because many people will reshape their wants and dreams to fit their cost structure. Happiness is frequently a choice, rather than an abundance of goods and experiences.
Regardless, once you have a spending goal, and your main risks are covered, then you have something to shoot for, and asset allocation can begin. In the process you might come up with a return target to shoot for, which I call Your Personal Required Investment Earnings Rate. The basic idea is this:
Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc. Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.
To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates. Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them. Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].
For more, you can read the article, which has a decent amount on whether return needs are reasonable or not. More on this topic when I try to describe setting asset earnings assumptions, which is decidedly more complex. Till then.