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Standard Asset Allocation Models Are Wrong: Dalbar

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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.

Growth Assets vs. Preservative Assets

In its report, Dalbar differentiates between growth assets, which are stocks, and preservative or protective assets, which include Treasury bills, notes and bonds; corporate bonds, money markets, CDs and annuities.

Prudent Asset Allocation uses protective assets, which are more predictable than growth assets, to meet the cash needs of investors while letting growth assets appreciate at their maximum rates.

Since 1928, Treasury bills, the asset “most suitable for preservation,” according to Dalbar,  haven’t lost money in any given year, and their median one-year gains have been 3%. During that same period the S&P composite has had a median one-year return of 14.2%, while the Nasdaq has returned a median 15.4%. Both stock indexes are the “least suitable” assets for preservation but the “most suitable” assets for growth, according to Dalbar.

Dalbar’s Prudent Asset Allocation combines the concepts of preservation and growth, using investors’ income and preservation assets to fund current, important expenses with as little risk as possible, and stocks to maximize asset growth over a longer period of time.

If an investor suffers equity losses in say, year two of the five-year period, or needs more funds due a change in circumstances, they will have the cash to tide them over without having to sell stocks, leaving time for their stock allocation to recover. They can also replenish preservation assets with their growth assets if that allocation runs now.

The strategy has “no need for rebalancing [because] the allocation is based on the funds actually needed by the investor,” according to Dalbar.

“You don’t know what will happen in the next year, but you won’t use up everything budgeted for the next five years,” said Harvey of the Prudent Asset Allocation model. He added it can also alert investors before they run out of money, providing the opportunity to reduce spending.

Pictured: Louis Harvey, Dalbar CEO and president