Asset Allocation - A new model for a new decade

Until now, financial practitioners have had to choose between simplistic asset allocation models that are inadequate for today's demanding investor, and sophisticated mathematical models, originally developed for institutional investors, that are inappropriate for individuals .

The most sophisticated existing models are based on Modern Portfolio Theory and the concept of the "efficient frontier". These models are mathematically impressive but are inappropriate for individual investors for a number of reasons:

• They require long-term historical analysis of returns, volatility and correlations among investments. For most investment funds, the available data is too recent and limited to be valid for this purpose.
• They assume that the future will be like the past, not only generally, but at a very detailed level.
• They assume that individual risk tolerance can be measured accurately, despite empirical studies showing that this is not possible.
• They are highly unstable; tiny changes in assumptions produce widely different results.

Still River has taken a new and different approach. Instead of looking at investment results as stand-alone mathematical realities, it recognizes that they are expressions of the underlying economy. Our Econometric Monte Carlo (EMC) model projects hundreds of possible future economic scenarios, some extreme, most of them closer to what the economy has actually done in recent generations. It also asks for the individual investor's financial goals, including cash flows into and out of their portfolio. The EMC Asset Allocation model then tests the ability of different portfolios to meet these goals across the entire gamut of potential economic futures. The selected portfolio is the one that best meets the investor's financial goals while controlling risks associated with volatility, loss of principal and lack of diversification.

Advantages of the EMC Model

• Regression to the mean. Recent events have reminded us that the more a market or investment diverges from its long-term trend, the more it is due for a correction. Although we can't reliably predict when major corrections will occur, we can confidently predict that they will occur. While the old asset allocation methods continue to push the most recent market miracle, the EMC model gradually moves assets out of those investments and into others that are closer to their cyclical lows.
• Buy low, sell high. Because the EMC model's strategy is to move out of a sector when the price soars, it encourages selling at a higher price than the purchase price. Existing allocation models built strictly on analysis of past performance implicitly employ a "buy high, sell higher" strategy, which can produce spectacular returns at certain times, and huge losses at others.
• Realistic expectations from newer investments. The EMC model treats each investment's relationship to the market and the economy as a whole. If a certain fund has been in existence only during a bull market (or a bear market), it is not rewarded (or penalized) because it has only gone up (or down). The EMC model projects appropriate rises and falls in that fund based on projected rises and falls in the entire economy/financial market.
• The many facets of "risk". Other mathematically sophisticated models tend to equate risk with volatility. To serious investors, risk does not mean volatility. It means: Will I lose my money? and Will I get what I'm expecting to get out of my investment? Volatility is only a part of the answer. The EMC model looks directly at the main question: How likely will a given allocation allow me to meet my financial goals?
• Intolerant of risk tolerance. Most other asset allocation methods require precise measurement of risk tolerance, despite clear evidence that it can be measured only very broadly, if at all. They then have to translate this unrealistically specific risk tolerance into an allocation that supposedly reflects it. Both of these steps are suspect at best, patently invalid at worst. The EMC model does not measure risk tolerance. It asks about specific goals, and about an investor's willingness to compromise on those goals if necessary. Results of the asset allocation analysis are compared directly to the investor's stated goals.

Other Nice Features of Still River's EMC Model

• Mortality risk taken into account. Just we model alternative economic scenarios, we also model alternative client mortality scenarios. Many of the alternative methods require the individual to guess when he or she (or a spouse) will die. The EMC model uses actuarial techniques to model various lifespan possibilities, and takes into account sex, smoking status and relevant health impairments in doing so.
• Inflation is not an issue. The EMC model does not require the individual to guess what future inflation rates might be. This projection is built into the system. All cash flows are in current dollars, so that the individual doesn't need to translate current needs into future inflated dollars.
• Risk of failure is allowed for. There can be no absolute guarantees, and therefore there is always some risk that even reasonable goals will not be met. Our EMC model takes this into account, and asks the user to indicate the degree of willingness s/he has to accepting some degree of failure. This way we account for variations in risk tolerance without having to try to measure it directly, because the individual's preferences are directly tied to the analysis of the various economic scenarios.
• Tax effects are included. The EMC model adjusts for the tax characteristics of different kinds of investment plans and products.
• Annual fees and expenses are included. The EMC model takes into account annual fund management fees and other annual fees normally associated with certain investment products.
• Data is current. With one click of a button, the user can update the EMC model daily to reflect the latest market conditions.
• The model can be customized. The EMC Asset Allocation demo model includes generic investment fund categories; however the system can be customized to include the specific options offered by an investment plan or product.

How to Find Out More

Review our more detailed analysis, "Asset Allocation for a New Decade" in PDF format. (You can also download a copy from our Download page).

Test drive our Asset Allocation model by downloading and installing our latest demo of RetirementWorks.

Contact us if you want information about customizing RetirementWorks for your plan or product.