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The Basic Idea |
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Your investment portfolio is not only about pursuit of returns; it is also about risk management.
Matching investment assets with capital expenditure needs, and matching investment cash flows with needed spending from investments are among the most important aspects of portfolio risk management.
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1. Maturity matching: You should seek a portfolio that has maturities and ready liquidity at predictable values at predictable times to fund your portfolio dependent expected capital expenditures (capital budget).
2. Cash flow matching: You should seek a portfolio that will provide sufficient cash flow to fund your expected spending (cash flow budget). If your investment cash flow cannot be sufficient to fund your spending, then the difference should be treated as an annual capital item handled by maturity matching under the capital budget.
3. Risk Limits: All the while, you need to be assured that you are being adequately compensated by cash flows and expected capital gains for the volatility and permanent capital loss risks you assume.
4. Asset Allocation: Your asset class selection and class target weights should be consistent with your capital budget, your cash flow budget, and your risk limits.
5. Process Management: The asset classes, target allocations and the securities selected to represent each class should be managed by a process that maintains the appropriate relationships between the capital budget, cash flow budget and risk limits (collectively, the management parameters). |
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| MATURITY MATCHING |
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You have certain known or potential capital expenditure goals and obligations that can be estimated as to amount and timing.
If you have significantly more assets than required to meet your ultimate goals and obligations, you may be able to assume high levels of risk with all of your assets to pursue gains.
If you don't have assets that substantially exceed your future needs, or if you simply want to conservatively manage what you have for whatever reason, these guidelines should be applied:
1. Obligations due within 1 year should be funded with money market assets.
2. Obligations due from 1 to 10 years should be funded with bonds in the same amounts as the obligations, and with average durations that match, or at least approximate, the timing of those obligations.
3. Obligations due in more than 10 years may be funded with fixed income assets or with assets with greater potential for capital appreciation, such as common stocks or certain other non-fixed income assets. |
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| CASH FLOW MATCHING |
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To the extent possible, the asset classes and the securities within the classes should be selected and weighted to provide investment income that at least matches the non-capital spending budget.
While capital spending is handled by matching with asset maturities, operational spending should be dealt with through investment income to the extent reasonably possible and consistent with risk limits.
Operational spending that cannot be covered by investment cash flow should be projected and treated as a scheduled capital expense with matching asset maturities. |
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| RISK LIMITS |
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A balance between growth potential and loss potential is essential.
The more mature the asset pool (the less ability to replace assets with future earnings) the more the balance should lean toward conservation and sustainability — reducing loss potential at the expense of growth potential.
The less mature the asset pool (the more the ability to replace assets with future earnings), the more the balance should lean toward potential growth with the associated assumption of more risk.
The risk budget should take into consideration at least:
- market risk (volatility, liquidity and valuation)
- credit risk (quality, duration and interest rates)
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| ASSET ALLOCATION |
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The classes in the portfolio should, to the extent possible, have low correlation of returns.
About 90% or more of portfolio return is generated by asset class selection and weights. Only about 10% or less of long-term return is generated by security selection. Therefore, time and effort is most effectively used concentrating on asset classes.
Asset classes should be considered in terms of long-term and short-term history, current market conditions, and expectations for future markets that will not be precisely like past markets. Substantial discussion of how and why classes may perform differently in the future is essential.
To prevent a single class from overwhelming the portfolio returns, the maximum weight should be 25% per class.
To assure that a single class has the potential to contribute meaningfully to portfolio returns; the minimum weight should be 5% per class.
To minimize exposure to security issue selection risk, no active management fund or non-core index fund should have a weight more than 5% (core, broad market index funds may be weighted to the extent of the asset class weight). No individual stock or bond should be weighted more than 1.5 to 2%.
The overall asset allocation plan should include a set of allocation policy target weights (target weights) for each class. A collar of minimum and maximum weights should accompany the target weights. That provides some short-term flexibility around long-term allocations. |
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| We prefer to sub-divide asset classes into these three categories: |
- Strategic Core
- Tactical Emphasis
- Active Focus.
Each sub-category should be given a minimum and maximum weight within the class. The result is a two-dimensional matrix of asset classes and asset class sub-categories. Specific securities are selected to represent each sub-category of each asset class.
It is only necessary to utilize the Strategic Core sub-category to build a perfectly adequate and simple portfolio. However, a progressively more complex portfolio can be developed by selecting securities for the Tactical Emphasis and/or the Active Focus categories
The Strategic Core should generally be populated with broad, diversified no-load, low expense funds, or ETFs.
Tactical Emphasis is generally populated with narrower no-load funds, ETFs or ETNs that increase the exposure to selected sectors, industries, regions or countries that are included in the broad funds of the Strategic Core.
Active Focus, if not left empty, is generally populated with specialty no-load funds or individual stocks or bonds. |
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