Risk Allocation and Buckets: How to Structure Your Wealth Effectively
Excerpt adapted from the Book:
The Aspirational Investor by Ashvin B. Chhabra
As we’ve seen, individuals and families needs an investing framework that delivers on three principal objectives:
- The certainty of protection from anxiety and poverty, or safety.
- A high probability of maintaining your standard of living, or stability.
- The possibility of achieving upward wealth mobility and creating the potential to meet your aspirations.
These three seemingly straightforward objectives form the foundation of the Wealth Allocation Framework. Importantly, Risk is re-defined as the probability of not meeting your essential and important goals and consideration is given to achieving Aspirational Goals. The Framework, then provides a pragmatic, multidimensional approach to managing risk in relation to your goals.
Risk allocation is achieved by creating three distinct risk buckets to support each of the corresponding three key objectives of your wealth management strategy.
The successful implementation of the Wealth Allocation Framework depends on properly classifying everything you own within three distinct risk classes or buckets: Safety, Market & Aspirational.
Personal Risk & Safety (Protective Assets)
Protecting your financial security means ensuring that no matter what happens in the markets, your essential needs are always covered. This is where Protective Assets come in: they provide stability and peace of mind, shielding you from financial uncertainty and helping you maintain your standard of living.
Market Risk & Market Exposure
To maintain your lifestyle, your investments need to keep pace with the rising cost of living. This means taking on market risk through exposure to Market Assets. As Markowitz explains, while some risk can’t be eliminated, it can be managed through strategic portfolio diversification.
Aspirational Risk & Aspirational Assets
In order to create the possibility of wealth creation and wealth mobility, or to fulfill your aspirational goals, you may decide to allocate Aspirational Assets to investments or business ventures that involve idiosyncratic risk and the potential for substantial capital gain or loss.
Because of its diversified nature, the market risk bucket is about statistically quantifiable risk—the focus of Markowitz’s pioneering work. The safety and aspirational portfolios, on the other hand, are about the risk and opportunity of uncertain outcomes, Knight distinguished between risk (measurable probability) and uncertainty (unknown probability), laying the foundation for modern risk theory. Mandelbrot challenged traditional financial models by highlighting the chaotic nature of markets and the frequency of extreme events. Their work highlights the unpredictable nature of financial markets.
In the Wealth Allocation Framework, risk allocation—that is, the allocation of your assets and liabilities among the three risk buckets—is more important than, and in fact must precede, both the selection of assets and the selection of investments and managers.
The Wealth Allocation Framework recognizes that there is no free lunch. Assets that provide safety and have the potential to hold their value in a market crash will not provide high return potential. Therefore, investments allocated to the personal risk bucket will be selected to limit the loss of wealth but will probably yield below- market returns. Allocations to the market risk bucket will provide risk-adjusted market returns, in accordance with the diversification principles of modern portfolio theory. Finally, allocations to the aspirational risk bucket should be selected to yield above-market returns, but they will carry the risk of substantial loss of capital.
In this manner, each of the three core objectives of your wealth management strategy is assigned its own unique risk profile and requires its own carefully constructed portfolio: a safety portfolio consisting of protective assets; a market portfolio with the objective of stability for the long term; and an aspirational portfolio to help you generate wealth to achieve your aspirational goals.
Here are a few ground rules for classifying assets and liabilities:
Safety & Protective Assets
If an investment provides safety and is thus characterized by below-market risk, then it belongs in the safety i.e. protective bucket. These assets will likely provide below-market returns but should provide protection during market downturns. Examples are Cash, Short duration Treasury bonds, Gold, Health insurance. Your home and its corresponding mortgage liability both end up in this bucket also. Finally, your human capital, or earnings potential, offset by any outstanding educational debt, also belongs in the safety bucket.
Market Assets
Assuming you are not overly concentrated in a stock, sector, country, or asset class, most conventional equity (stocks) and fixed-income (bonds) securities fall into the market bucket, as long as they are sized appropriately as part of your diversification strategy. Alternative investments, such as a fund of hedge funds or commodity or private equity or venture or real estate funds, may also belong in the market bucket if these investments are held for diversification purposes.
Aspirational Assets
Finally, if an investment has the potential for above-market returns, it must also possess above-market risk, and thus belongs in the aspirational bucket. Any concentrated or leveraged positions also belong in the aspirational bucket. Assets that fall into the aspirational bucket include early-stage “angel” or venture investments, as well as family-owned businesses that make up a significant portion of an individual’s net worth. In addition, the aspirational bucket includes executive stock options, concentrated stock positions, single-manager hedge funds, leveraged investments in real estate, and opportunistic call option instruments. Assets in this bucket are riskier than the market in general and include the possibility of catastrophic failure and loss of principal.
Liabilities
Working through the liability side of your personal balance sheet is similarly straightforward. All personal liabilities and debt should be allocated to the safety portfolio, where they reduce the size of your personal safety net. The only exceptions—non-recourse loans attached to specific investments—should be placed in the same buckets that hold those particular investments. In similar fashion, these loans will reduce the value of the corresponding asset.
Although it is not difficult to objectively assess the suitability of different assets and securities for each risk bucket, you must consider both the risk and return profile of the investment and the purpose it serves in your portfolio to determine the appropriate placement. This is why different investors may sometimes place the same security in different buckets: placement depends on how the security is being used in the portfolio. As noted above, the three-bucket Wealth Allocation Framework provides no free lunch. As such, there are only three categories for your assets: low-risk with low return; market risk with market return; and high return potential with high risk. There is, alas, no low-risk, high-return bucket!
A parting thought…
The Wealth Allocation Framework is carefully designed to be logical, intuitive, and simple to understand. The key to risk allocation is not only understanding the particular characteristics of your various assets but also thinking carefully about the role they play in your portfolio. Within the Wealth Allocation Framework, this novel exercise in risk and resource management can be illuminating—and surprising.