Approaches to asset allocation
There are at least three approaches to asset allocation: an asset-only approach, a liability-relative approach, and a goals-based approach. On this page, we discuss the objectives of each of these approaches. They have in common the objective to match investors’ goals with their optimal level of risk.
The first approach we discuss is the asset-only approach. Under the asset-only approach, asset allocation decisions are based solely on the investor’s assets. An example of an asset-only approach is mean-variance optimization. This approach incorporates expected returns, volatility, and correlations of asset classes. The objective is to maximize the Sharpe ratio. The investments will typically consider the investor’s constraints as well as the investor’s risk tolerance.
A second approach is the liability-relative approach, sometimes also called liability-driven investing (LDI). Under the liability-relative approach, asset allocation decisions are based on funding liabilities. The objective is to pay the liabilities as they come due. An example of a liability-relative approach is surplus optimization. The surplus is computed as the investor’s asset value minus the present value of investor liabilities. Liabilities are typically modelled by shorting an amount of bonds whose duration matches the duration and present value of liabilities.
The third kind of approach we discuss is the goals-based approach. Under the goals-based approach, asset allocation is applied to sub-portfolios that help investors to achieve certain lifestyle and aspirational financial objectives. For example, goals could involve maintaining the current lifestyle or donating money to a university. To achieve the stated goals, it is necessary to specify the types of cash flows needed, the time horizon, the level of risk tolerance,… . Combining all the sub-portfolios will yield the overall portfolio. The approach is also referred to as GBI or goals-based investing.
Both liability-driven and goals-based approaches are focussed on meeting liabilities. The difference is that liability-driven approaches are used by institutional investors whereas goals-based approaches are used by individual investors.
We discussed three approaches to asset allocation that are very popular: asset-only approaches, liability driven approaches, and goals based approaches.