In: Finance
Which of the following statements is incorrect regarding Bucket based asset allocation?
Group of answer choices
Investors are able to change allocation of assets within, and across, each bucket based on changes in investment objectives.
Asset allocation based on "Three Buckets" is inferior to Mean-Variance allocation that uses historical risk, return and correlation for each asset since the MV framework is backed by a sound theoretical framework.
A "Three Bucket" based asset allocation allows for better allocation of risk than a Risk Parity portfolio, since portfolio managers can choose the level of risk allocation or types of investments to each bucket.
Allocation to each bucket in a "Three Bucket" asset allocation is based on investors' investment objectives.
Allocation of assets within each bucket can be done either through a quantitative methodology or a qualitative methodology which considers the inherent nature of each asset that is considered to be included in the portfolio
Answer- Asset allocation based on "Three Buckets" is inferior to Mean-Variance allocation that uses historical risk, return and correlation for each asset since the MV framework is backed by a sound theoretical framework.
Bucket based asset allocation
Asset allocation is traditionally conceived in a mean-variance framework pioneered by Harry Markowitz, where an investor strives to maximize the expected return for a given level of risk.
However, this conventional approach does not consider three important aspects of investing:
Daniel Kahneman, a Nobel Prize winner in behavioral finance, argued that investors are not always rational in their decision making, saying, “Economists think about what people ought to do. Psychologists watch what they actually do.”
Accounting for these behavior gaps is the essence of the bucketing approach to financial planning.
Mental Accounting
One of the major behavior gaps the bucketing approach tries to alleviate is mental accounting, the theory that people treat money differently depending on its origin and intended use. Investors are susceptible to this bias when they view recent gains as “house money” that can be used for high-risk investments, according to Richard Thaler’s study “Mental Accounting Matters.”
The bucketing strategy lays the foundation for goals-based allocation, which provides a tractable shortcut to overcoming a one-number risk in a portfolio. This approach divides a client’s portfolio into several “buckets,” each with different goals, time horizons and risk levels. Each bucket is driven by a separate asset allocation policy that creates a case-by-case, tailored solution that reflects a client’s financial plan.
Time Diversification of Risk
The bucketing strategy also infuses “time diversification,” the theory that there is an inherent relationship between the holding period and risk – the volatility of risky assets falls over long periods of time.
This has long been debated in academia with the acceptance of what is known as “mean reversion” of returns. Several theories are used to explain mean reversion in stock prices, but ultimately it’s said that an upward price movement is likely to follow a decline in stock prices, and vice versa.
The variance of stock returns is less than proportional to the time horizon, which supports the case that stocks are less risky over the long-run, as evident by the S&P Composite Index (charted below).
J.P. Morgan Guide to Markets 4Q 2019 as of September 30, 2019
Even in a shorter cycle, S&P annual returns are positive in the last 29 out of 30 years despite an average intra-year decline of 13.9%. Studies indicate that short-term focused investors lost over 60% of the returns available in their time horizon due to poor market timing, which was driven by emotional decision-making with greed or fear as a factor.
The Sequence of Returns Paradox
Sequence of returns has become essential to determining the ending value of portfolio wealth. Sequence of returns risk relates to the heightened vulnerability that retirees face with the realized investment portfolio returns in the years around their retirement date.
Moshe A. Milevsky and Alexandra C. Macqueen wrote in “Pensionize Your Nest Egg” that investors are most at risk from a negative sequence of returns during what is called the “retirement risk zone” – the years immediately preceding or following retirement. Many who retired around the recession in 2008 experienced this. The retiree has the largest nest egg at hand with a shorter time horizon to recoup the losses from market downturns.
However, Milevsky and Macqueen claim that the bucketing approach gives an illusion of safety because an investor draws from a near-term bucket of cash or cash equivalents and empties it, and the longer-term bucket allocation drifts toward more equities with higher volatility.
This implies the bucketing portfolio is somewhat less exposed to equity risk at the beginning, when withdrawals are taken from the less risky assets, and more exposed to equity volatility toward the end of the period.
Testing the Efficacy
To model the portfolio construction, let’s simulate and compare the results of a traditional 60/40 portfolio with a 4% systematic withdrawal to a two-bucket portfolio that invests 40% in Bucket 1 and 60% in Bucket 2.
There is a waterfall distribution from Bucket 2 to refill Bucket 1 at the end of each year over a 20-year time horizon.
Traditional Portfolio Construction
Bucketing Portfolio Construction
The Bucketing portfolio was constructed with an initial investment of $1 million, allocated as follows:
The parameters of the bucketing portfolio model are in the
appendix.In other words, there is no difference in investment
between traditional and bucketing portfolio other than splitting
the funds into two buckets.
Observations
Source : Hartford Funds Research
Key Takeaways
Closing Thoughts
Accounting for investor behavior is an important part of financial planning, and the bucketing approach is one way to account for this factor.
While bucketing can vary depending on the number of buckets, the length of time and the risk level of each bucket, it is an effective strategy to alleviate sequence of returns risk and protect against emotional reactions to the market.