Understand Your Liabilities

 

Photo Credit: Teresa Robinson || Your plans, your needs, your dreams, your risks…

What I am going to write here is half of my summary of how Asset Allocation is done. Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.

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Good asset allocation, and financial planning generally, focuses on two main questions:

  • When will the cash be needed for expenses?
  • What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed? Also, how likely are those returns?

Tonight I am writing about the first question. For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place. (The same applies to financial institutions, though for institutions with short-term funding profiles, you won’t typically use actuaries, not that you couldn’t.)

For individuals and families, the issues come down to needs, wants, dreams, and risks. As for risks, you can look at the earliest series at my blog, [summary here] which was on personal finance. (I never intended to write much on personal finance, and so that was a summary set to get my main ideas out.)

Then comes the hierarchy of expense: needs, wants, and dreams. Aim to satisfy each one successively. Some people can only afford needs, others can get to wants, and a few others can get to dreams. Now, that’s an oversimplification, because many people will reshape their wants and dreams to fit their cost structure. Happiness is frequently a choice, rather than an abundance of goods and experiences.

Regardless, once you have a spending goal, and your main risks are covered, then you have something to shoot for, and asset allocation can begin. In the process you might come up with a return target to shoot for, which I call Your Personal Required Investment Earnings Rate. The basic idea is this:

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc. Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates. Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them. Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

For more, you can read the article, which has a decent amount on whether return needs are reasonable or not. More on this topic when I try to describe setting asset earnings assumptions, which is decidedly more complex. Till then.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.