A Sensible Approach to Allocating Wealth

At HTG Investment Advisors, we believe in applying well-researched techniques to benefit our clients. One such technique is the Wealth Allocation Framework (“WAF”) developed by Dr. Ashvin Chhabra, a close friend and former colleague of mine. WAF draws on the behavioral finance research of Amos Tversky and Daniel Kahneman who are the subjects of Michael Lewis’ latest book, The Undoing Project.

Humans are Wired to Invest Poorly

Kahneman and Tversky’s collaboration led to a number of important discoveries of how humans react to financial risk and reward. For example, when faced with a loss, humans are more likely to take additional risk to avoid realizing that loss. In addition,  humans apply different rules when placing bets with winnings as compared to their initial principal. In recognition of their work, the 2002 Nobel Prize was awarded to Dr. Kahneman (Dr. Tversky unfortunately had passed away). The Wealth Allocation Framework builds on their research by identifying three separate categories of financial goals, each with an appropriate risk level.

1) Safe Assets – your sleep-well-at-night money
What amount of safe and easily accessible money would you want in order to feel confident you could weather difficult times? If you set aside enough money to fund three years of your budget for housing, food, transportation, healthcare and basic entertainment would that be sufficient? Would five years provide greater comfort?

Safe assets are cash, bank deposits, quality fixed income, your primary residence, Social Security, guaranteed pensions, and highly-rated life and disability insurance policies. Most important is sufficient liquidity to fund your basic lifestyle during a prolonged drop in the stock market or gap in employment. There is no point in having wealth if you need to worry about paying your monthly bills.

2) A Diversified Investment Portfolio – for lifestyle maintenance over time
While your safe assets provide peace of mind in the near-term, they do not over longer time horizons. A couple who is 65 today have a 40% probability that one of them will be alive in thirty years. Higher returning assets, along with their higher volatility levels, are required in order to keep up with increasing lifestyle costs and taxes. To best achieve this objective, the portfolio needs to be diversified across investments with different sources of risk.

3) Aspirational Investments – taking bigger risks to create greater wealth
If one of your goals is to seek exceptional returns in the hope of a material increase in wealth, then you should apply any specific advantage you have. You may have a skill at identifying significantly mis-priced securities or have access to investments not available to others. Some investors choose to remain concentrated in a sector or stock they know well. In contrast, relying exclusively on luck and buying Powerball tickets is less successful. Your aspirational allocation should never be greater than what you can afford to lose.

Honest Risk Assessment Required

A benefit of the Wealth Allocation Framework is its flexibility. The family business should be included under “Aspirational”. Human capital, an individual’s accumulated skills and experience, can also be an aspirational asset if unique and highly valued. For an asset to be included in the WAF, there must be a fair market value and an honest assessment of risks.

The Value of Simplicity

The three risk groups are easy to remember and discuss with appropriate family members. A clear understanding of how a family’s wealth is invested increases everyone’s conviction to stay the course when an unforeseen event occurs.

One of the greatest risks to sustaining wealth is letting emotions drive a change in strategy at the wrong time.

Resonates with Many

We have applied WAF in a variety of situations with positive results. For example, a couple disagreed on how much total risk to take. He was concerned they were taking too much risk while she wanted to increase their commitment to interesting investment opportunities. We segregated the safe assets from the aspirational ones which helped them discuss the relative size of each risk group.

In another situation, an investor was having difficulty measuring progress of a single large portfolio of both market driven investments and individual securities selected for their expected appreciation. Applying WAF, we separated the portfolio in two: one part focused on protecting his lifestyle over the long term and the other on risk-taking in pursuit of additional wealth creation.

If the Wealth Allocation Framework is of interest to you, we would be delighted to schedule a meeting to explore its application.

To read more about allocation and investing, read our Three Tips to Investing Without a Crystal Ball and Tax-Smart Techniques for Managing Portfolios.

Lex Zaharoff, CFA

Lex joined HTG in 2014. With over 30 years of experience advising wealthy families at four major private banks, Lex provides clients with a unique perspective on the art and the science of investing to achieve one’s financial goals.

As Adjunct Professor of Finance at NYU’s Stern School of Business, Lex teaches the MBA course on wealth management. He has a BSE from Princeton University and an MBA from Harvard Business School.