What You Need to Know
- The approach, called Prudent Asset Allocation, is based on investors' cash needs for the next five years.
- Since 1940, the longest recovery period for any major downturn in the S&P has been five years.
- PAA combines preservation assets like Treasury bills for investors' cash needs with growth assets, namely stocks.
Financial advisors who allocate client assets based on clients’ cash needs for two to three years in the future are making a mistake, according to Dalbar, a financial services research firm.
In a new report, Dalbar founder and president Louis Harvey writes that asset allocations for clients should be based on their cash needs for five years. Why? Since 1940, five years has been the longest period for the S&P composite index to recover its losses from any downturn.
“This is very seldom done,” Harvey told ThinkAdvisor, adding that advisors who just focus on asset allocation and don’t create financial plans often don’t consider clients’ cash needs at all.
The Dalbar paper differentiates between Arbitrary Asset Allocation (AAA), which omits any consideration of cash needs, and Prudent Asset Allocation (PAA), which uses five-year cash flow needs.
“AAA allocations are based on an arbitrary standard, set and changed by the allocator … [using] risk tolerance, passage of time, simulations or institutional guidelines,” according to the Dalbar report. They often omit an investor’s cash holdings if the investor hasn’t volunteered that information or the advisor hasn’t asked about cash holdings, according to Harvey.
PAA allocations, in contrast, “are based on the funding needs of an investor and on changes in those needs … [and] on the market’s historical ability to recover from severe declines,” according to the Dalbar report.
“If you can tell me what you’ll need for five years, that’s how much you should hold in cash or bonds. Everything else is in stocks,” said Harvey.
Included in those cash calculations are an investor’s cash flow from Social Security, annuities as well as cash equivalent securities such as CDs. Before retirement, they include salaries.