Wealth Allocation Framework Defined Part II

I'll briefly go over the basic concepts of the Wealth Allocation Framework, and refer you to Ashvin Chhabra's "Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors" for details.

The reason the Wealth Allocation Framework appeals to me is because while reading the article, I realized that I had already started implementing this framework. The article formalized the allocation strategy I've been working on the last few months. The strategy is easy to understand and intuitive, so it makes perfect sense to me.

The problem with Modern Portfolio Theory is that at times the portfolio can still be too volatile (depending on the timeframe that performance is being measured at), and it does not consider my personal life and goals. The main reasons I would be disinclined to solely follow MPT are:

1. In serious bear markets, the stock allocation would make me uncomfortable. I'd have a difficult time watching my portfolio drop 25-50%, and would be tempted to take trading positions.
2. In a strong bull market, I'd be kicking myself for not having a more concentrated position in winners, which would greatly outperform the general market (this outperformance is one way of aspiring to move up in wealth percentile).

The Wealth Allocation Framework addresses these main issues. The strategy recommends allocating my assets into three categories: personal, market, and aspirational assets.

The personal assets are ones that I do not want to jeopardize under any circumstances. These assets are my protection for maintaining my standard of living. Even if all world stock markets and all real estate valuations go to zero, these assets would remain mostly intact. The appropriate level for personal assets would vary from household to household, and even for a single household over time. At my stage, personal assets include the roof over my head, and a comfortable level of stable investments in CDs, treasuries, munis, cash. Later, they may include life insurance, annuities, etc. Just beating inflation is a good goal for these assets.

The market assets allow me to keep up with the Joneses. These diversified assets should perform at the level of the general market. They would include mutual funds, managed funds, some bonds, small individual stock holdings, unleveraged rental property, small amounts of alternative investments for the purpose of diversification, small businesses, etc. These assets can be allocated according to Modern Portfolio Theory.

Finally, the aspirational assets are my longshot investments. If they succeed, my wealth percentile improves. If they fail, my lifestyle is not affected, and my risk is limited. This is money I can accept losing. These assets include leveraged real estate investments, private equity deals, risky business ventures, lottery tickets, a healthy dose of my company stock options, etc.

Over time, as one's wealth increases, the ratios of these assets would evolve. I may decide to move into a bigger home, thus increasing my allocation into personal assets. Eventually, I may decide that I have more than I'll ever need in my personal assets, and start allocating gains only into aspirational assets (this is what most rich people do, which is why the rich keep getting richer).

Judging from family, friends, and PF blogs, I feel that many people are financially lopsided, i.e. they are either too conservative or too aggressive. They either hold too much cash from apathy or fear, or they take on too much risk to try to outperform or "get rich quick".

In part III, I will describe plans for allocating my personal assets into the Wealth Allocation Framework.