Risk and reward in investing are often defined in terms of the nominal dollar value of the portfolio: dollar gains, dollar losses, dollar volatility, dollar value at risk, and so on.
But these are only indirectly related to the real goals of individual or institutional investors. Would it be better to explicitly focus on investors’ objectives over an investment horizon and manage assets accordingly? We believe in this increasingly popular approach and propose the following 4×4 superstructure for goal-based investing.
Four goals
The assets and liabilities of any portfolio must contribute to:
- liquidity Maintenance: have a pool of nominally safe and quickly accessible “cash-like” assets. Cash reserves cushion portfolios in crises and serve as “dry powder” stores to potentially buy down assets during fire sales.
- income Generation: relatively regular, certain, and short-term cash payments such as coupons, dividends, and proceeds from sales of appreciated assets managed by systematic taxes.
- conservation of capital (real): assets should maintain their real value over time, despite the uncertain future outlook for inflation. Commercial and residential real estate, commodity-related assets, and collectibles, for example, can contribute to this goal.
- growth: more volatile assets and strategies that are expected to generate higher future cash payments. Most private and public (growth) stocks, as well as cryptoassets and other “moonshot” investments (in options terms, think of these as deep out-of-the-money calls) should help achieve this.
In a balanced and diversified portfolio, all four objectives should have “power”. That’s why we named our strategy 4×4.
Four investment objectives, time horizons and cash flow characteristics
How can we put these concepts into practice in an investor-specific way?
First, we start with investor preferences, expressed by three variables.
- T is the strategic investment horizon over which the investor seeks to achieve his goals, for example five, 10 or 30 years; an age-dependent horizon; or even “forever”.
- t is the tactical rebalancing / trading frequency, for example a day, a month or a quarter.
- B is the “substantial loss” barrier – what kind of withdrawal will the investor be comfortable with? The loss barrier can be mapped to the risk aversion parameter using a power function. For example, for an investor with more risk, the loss of B= 15% of your net worth could involve the same energy loss utility as the loss of B=3% for a more risk-averse investor.
We then determine, based on investor preferences, how much each asset contributes to each of the four objectives. We propose the following approach to 4×4 asset allocation:
For each asset/liability we distinguish between “return of capital” cash flows (final sale / disposal / maturity of the asset) and cash flows of “return of capital”, or coupons, dividends , real estate rental, futures “return” “Carry” of currencies, royalties, systematic sales of appreciated assets with tax management, work-related income, etc. Although this distinction may seem artificial and ambiguous, we believe that the implications for liquidity, transaction costs, taxation, accounting, and ultimately reallocation decisions are important enough to justify a separate consideration of these two types of cash flow.
Next, we separate the “return of capital” cash flows into two compartments: liquidity and preservation. Heuristically, liquidity is quick and easily accessible and the least volatile part of cash flows, whereas preservation – in particular, protection against inflation — it is driven by potentially more volatile investments that are expected to hold their real value if held for longer periods.
We also break down the “return on capital” cash flows into revenue and growth. For us, income it is the closest and safest part of the return activated capital flows, i growth it is the most distant and volatile aspect of return activated capital flows.
To formalize and quantify this intuition, we apply option pricing theory. Each asset/liability is assigned to four “virtual portfolios”: Liquidity, Income, Preservation and Growth based on the investor’s preferences. Each asset/liability contributes to the four goal areas in an investor-specific way.
For illustrative purposes, imagine a high net worth individual with a strategic horizon T=10 years and a certain schematic portfolio allocation derived from two sets of preferences. The former is more searching and risk tolerant with frequent tactical rebalancing 1 year and the “substantial loss” barrier. B=15%, and the second is more risk-averse with the frequency of tactical rebalancing 1/52 years, or a week, and the “substantial loss” barrier. B= 3%.
Based on these preferences, the same portfolio maps differently to the four objectives.
Examples of 4×4 decomposition
In addition, we propose advanced portfolio construction techniques to create optimal investor-specific strategic and tactically rebalanced 4×4 portfolios.
Strategic investment horizon T and Tactical Rebalancing Frequency t
Investors who focus solely on the nominal dollar prices of assets often neglect one or more of the four objective categories. Even asset-rich individuals and institutions can experience cash flow or liquidity problems, especially in turbulent market conditions. This can lead to fire sales of assets at depressed prices. Other investors may be too risk averse and miss opportunities to grow their assets or hedge against inflation. Others may be prone to myopia and fail to balance their strategic and tactical objectives and risks in a disciplined manner.
With explicit strategic portfolios, rebalanced with tactical frequency to align with strategic objectives and take advantage of near-term opportunities, our 4×4 asset allocation is a well-suited framework for building a truly balanced and diversified portfolio.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Max Goltz, PhD
