Adjust Your Asset Allocation so You Can Outwait a Distressed Market

There’s no shortage of articles that attempt to explain the art of creating the best asset allocation for your portfolio. One reason why is that most financial professionals have a unique approach to this task — but one must remember that the purpose of seeking an ideal asset allocation is to minimize portfolio volatility based on your risk tolerance.
 
Most traditional wealth management firms attempt to discover your risk tolerance by giving you a 10–20 question questionnaire designed to estimate the amount of risk you can emotionally withstand during inevitable stock market fluctuations.
 
Traditionally, it’s results from such questionnaires that determine asset allocations. In contrast, I believe that your portfolio’s asset allocation should be developed with a more personal approach that considers your liquidity needs over a specified period.

Determining Your Liquidity Needs 

The first step to developing asset allocation using this method is to determine the annual liquidity you may need from your portfolio. This task is difficult to do well because you must be as precise as possible. Ideally, the yearly breakdown within your projections should show all income (including projected investment income) and expenses (including taxes and estimated saving amounts). In addition, you will also need to know which account (i.e. 401(k), traditional individual retirement account, brokerage and Roth IRA) the estimated liquid­ity need will be pulled from. 
 
Once you identify the years in which you may need to liquidate equity portions of your portfolio to meet your cash flow needs, you can determine how much of your portfolio will be in fixed versus growth investments. (And for years when you don’t need to liquidate, you can simply leave those funds in an equity position.)
 
If your cash flow projection indicates you’ll need liquidity from your equity investments, then you should sell the required amount and place the proceeds within cash or fixed investments.
 
Building this kind of “living” asset allocation based on cash flow liquidity needs gives you the power to meet future needs or spending goals when needed, without having to sell in a down market.
 
For younger clients who could be many decades out from retirement, portfolio liquidity needs might include a wedding, buying a new home and paying for college. Retirees, on the other hand, may use this strategy to account for supplemental cash flow for living expenses, home repairs or upgrades, gifting to heirs and required minimum distributions.  

Adjusting for Risk Based on Liquidity Needs   

The likelihood of your investment yielding a positive return increase as your time horizon increases. Your time horizon is the amount of time between today and the point at which you want to sell your investments and access the funds.
 
Your chances of success in the market rise the longer you invest because the market generally increases in value over time. Based on the historical behavior of the market, if you invest in the S&P 500 and hold that position from one day to one year, your chances of a positive return are approximately 53% to 74%. Holding that same position over five, 10 and 20 years increases your chances of yielding a positive return to 87%, 94% and 100%.
           
These facts point to another important reason to build your asset allocation depending on your liquidity needs: Should an investor withhold any liquidity needs within the first five years from equity participation, then they will be able to wait out a distressed market for at least five years.
 
This will give their portfolio an 87% chance of recovering any losses or even producing a positive return. To improve your odds even further, you can set aside the first 10 years of your liquidity needs in cash or fixed investments for a 94% chance of a positive return and 20 years’ worth of liquidity needs for a 99%-100% chance.

Building an Asset Allocation Based on Liquidity Needs Allows Investors to Play Defense

One of the most significant risks you need to safeguard against when withdrawing from your portfolio is substantial negative returns. When your portfolio experiences losses early during the time period where you make withdrawals, you face a greater risk of running out of money down the road than you would if your portfolio experienced the same degree of loss but at a later point on your timeline of withdrawals.
 
The Great Recession showed us just how devastating this could be. Between December 2007 and June 2009, the S&P 500 lost over 50%. The average person inside of a 2000-2010 target-date fund experienced losses of over 20%, while investors who held shares from the now defunct Oppenheimer Transition 2010 fund would have seen losses of more than 40%.
 
If you were in these funds and planned to retire in 2010 (as participation in these particular target-date funds would indicate), then your assets took significant hits due to market movements and you would have worsened the impact if you also needed to make withdrawals at the same time.

Using an asset allocation on liquidity needs, however, could have put you in a position where a set number of years’ worth of liquidity was already sheltered from the worst of the blows to equities during the Great Recession. That would have allowed you to play defense while the market was down and given you a way to weather the storm.
 
Building a liquidity-based asset allocation has many benefits for investors in various stages of the wealth-building process. Whether you’re about to retire or are younger and have many decades to accumulate assets, a portfolio that considers your liquidity needs throughout life can provide you with the funds you need when you need them — while also protecting you from investment risks including market timing, liquidity risks and sequence of return risks.
 
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This article was originally published in the October  2020 issue of BetterInvesting Magazine.

Malik S. Lee, CFP, CAP, APMA, is managing principal of Felton & Peel Wealth Management based in Atlanta and New York. He can be reached through their website www.FeltonandPeel.com.

 

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