- Risk and reward in investing should be based on achieving investor goals over a long-term investment horizon.
- There are four key goals in investing: liquidity maintenance, income generation, preservation of capital, and growth.
- Each asset contributes differently to these goals, and a balanced and diversified portfolio should address all four goals.
- Investors should consider their strategic investment horizon, rebalancing frequency, and risk tolerance when constructing their portfolios.
- A 4×4 asset allocation approach can help investors achieve their goals by focusing on liquidity, income, preservation, and growth.
In investing, the focus is often on the nominal dollar value of a portfolio and the associated risks and rewards. However, it may be more effective to explicitly focus on investor goals and manage assets accordingly. This approach, known as goals-based investing, involves defining and managing assets in relation to specific investor goals over a long-term investment horizon.
There are four key goals that should be addressed in any investment portfolio: liquidity maintenance, income generation, preservation of capital, and growth.
Liquidity maintenance refers to having a safe and quickly accessible pool of assets, which can serve as a cushion during market crises and allow for potential opportunities to buy depreciated assets.
Income generation involves generating regular, certain, and near-term cash payments, such as coupons, dividends, and systematic tax-managed asset sales.
Preservation of capital focuses on assets that retain their real value over time, despite the uncertain future outlook for inflation. Examples of such assets include commercial and residential real estate, commodity-related assets, and collectibles.
Growth involves more volatile assets and strategies that are expected to generate higher future cash payments. This can include private and public equities, as well as investments in cryptocurrencies and other high-potential opportunities.
In a balanced and diversified portfolio, all four goals should be addressed. This is why the 4×4 asset allocation strategy is proposed. This strategy involves mapping each asset to its contribution to each goal and managing the portfolio accordingly.
To implement goals-based investing, investors need to consider their strategic investment horizon (T), the frequency of tactical rebalancing/trading (τ), and their willingness to tolerate substantial losses (B). These variables can vary depending on individual preferences and risk tolerance.
For example, a risk-seeking investor may have a strategic investment horizon of 10 years, a tactical rebalancing frequency of one year, and be comfortable with a substantial loss of 15% of their net worth. On the other hand, a risk-averse investor may have a shorter strategic horizon, more frequent rebalancing, and a lower tolerance for substantial losses.
By considering these preferences, assets can be allocated to the four goals in different ways. For example, an asset may contribute more to liquidity and income for a risk-averse investor, while it may contribute more to preservation and growth for a risk-seeking investor.
To construct an investor-specific portfolio, advanced portfolio construction techniques can be used. These techniques aim to create strategic and tactically rebalanced portfolios that align with an investor’s goals.
Investors who focus solely on the nominal asset dollar prices may neglect one or more of the four goal categories. This can lead to cash flow or liquidity problems, missed growth opportunities, or a failure to protect against inflation. By using the 4×4 asset allocation framework, investors can construct a truly balanced and diversified portfolio that addresses all four goals.
It is important to note that the opinions expressed in this article are those of the author and should not be construed as investment advice.
