4 × 4 Asset Allocation: Four goals on an investment horizon

Investment risk and rewards 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 focus on investor goals and manage assets accordingly in an investment horizon? We believe in this increasingly popular approach and recommend the following 4 × 4 super-structures for goal-oriented investments.

Four goals

Assets and liabilities in any portfolio should contribute to:

  1. Liquidity Maintenance: Having a pool of nominally secure and quickly accessible “cash-like” assets. Cushion saves the portfolio in a cash crunch and serves as a store of “dry powder” for the purchase of potential undervalued assets during the fire sale.
  2. Income Generation: Relatively regular, fixed, and near-term cash payments, such as coupons, dividends, and systematic tax-managed accrued asset sales proceeds.
  3. Save (Real) Capital: The real value of assets should be maintained 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.
  4. Increase: More volatile assets and strategies that are expected for higher future cash payments. Most private and (increased) public equities, as well as cryptocurrencies and other “moonshine” investments – alternatively, think of them as deep-out-of-the-money – should help to accomplish this.

In a balanced and diverse portfolio, all four goals should be “driven”. This is why we dubbed our strategy 4 × 4.

Features four investment goals, time horizon and cash flow

Chart 8 showing the four investment goals, time horizon and cash flow characteristics

How can we put these ideas into practice in an investor-specific way?

First, we begin with the investor preferences expressed by the three variables.

  • T. Strategic investment horizons where investors want to achieve their goals, say five, 10 or 30 years; An age-dependent horizon; Or even “forever.”
  • 3 Strategic rebalancing / trading frequency, for example, a day, a month, or a quarter.
  • B “Significant Loss” Barriers: What Kind of Investors Will Be Comfortable with a Draw? Loss barriers can be mapped to risk-resistance parameters using a power utility function. For example, for a more risk-seeking investor, the loss B= 15% of their net worth could mean the same loss-of-power utility loss BFor more risk-resistant investors = 3%.
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Next, we determine how much each asset contributes to each of the four goals, based on investor preferences. We propose the following method of allocating 4 × 4 resources:

For each asset / liability we distinguish between “capital return” cash flows – final sale / disposal / maturity of assets – and “return on capital” cash flows, or coupons, dividends, real estate rentals, futures “roll returns,” FX. Carrying, “royalties, systematic tax-managed sales of acclaimed assets, labor-related income, etc. While this distinction may seem artificial and vague, we believe it has the effect of liquidity, transaction costs, taxes, accounting, and ultimately reinstatement. Allocation decisions are important enough to consider these two types of cash flows separately.

We then separate the “return of capital” cash flow into two buckets: liquidity and conservation. Heuristically, Liquidity Quick and easily accessible and less volatile part of cash flow, while Save – In particular, inflation protection The potential is driven by more volatile investments that are expected to retain their true value if retained for a longer period of time.

We also divide the “return on capital” cash flow between income and growth. For us Income The return is near and sure part On Capital flows, and Increase The more distant and unstable direction of return On Capital flows.

To formalize and measure this insight, we apply alternative price theory. Each asset / liability is mapped to four “virtual portfolios”: liquidity, income, savings and growth based on investor preferences. Each asset / liability contributes to or avoids four target areas in an investor-specific way.

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Imagine for a second you were transposed into the karmic driven world of Earl T.= 10 years and a specific planned portfolio allocation derived from two preferred sets. The first is more risk-seeking and risk-tolerant, with strategic rebalancing frequencies. 1 Years and “adequate damage” barriers B= 15%, and the second is more risk-resistant with strategic rebalancing frequency 1/52 Year, or a week, and its “significant loss” barrier B= 3%.

Based on these choices, the same portfolio maps differently with four targets.

Example of 4 × 4 digestion

Further, we offer advanced portfolio building strategies to create investor-specific strategic and strategically balanced 4 × 4-optimized portfolios.

Strategic investment horizons T. And strategic rebalancing frequencies 3

Investors who focus only on the value of the nominal asset dollar often neglect one or more of the four target segments. Even wealthy individuals and organizations can suffer from cash flow or liquidity problems, especially in a volatile market situation. This can lead to a fire sale of assets at depressing prices. Other investors can be very risk-averse and miss out on opportunities to increase their assets or protect against inflation. Still others may be prone to myopia and fail to balance their strategic and tactical goals and risks in an orderly fashion.

With clear strategic portfolios, balanced in strategic frequency to re-align with strategic goals and take advantage of short-term opportunities, our 4 × 4 asset allocation is a framework suitable for building a truly balanced and diverse portfolio.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not reflect the views of the CFA Institute or the author’s employer.

Image Credit: © Getty Images / Arctic-Images

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Max Goltz, Ph.D.

Max Goltz, PhD, chief investment officer of 4×4 Investments. Previously, he was a portfolio manager at Acadian Asset Management, a strategist at SSGA and Fidelity Investments, and a senior research analyst at GMO. He holds a PhD in mathematics from Yale University.

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