Posted on December 1, 2008 by David Laidlaw
Given significant losses of capital, the most pressing question is how to allocate portfolios now. In the past, stocks have typically rebounded from sharp selloffs. However, there is the potential that stocks will continue decreasing in value or stagnate for a long period of time. Therefore, as a simple starting point, we recommend that each individual and institutional client maintain five years worth of future cash withdrawals in cash and high-quality fixed-income securities.
There are many more complicated methods to determine a proper asset allocation between equities, fixed-income and other asset classes. Many institutional pension plans use liability matching to better inform plan allocations. A pension plan (and any investment portfolio for that matter) has a stream of expected cash withdrawals associated with it that will be necessary to fund future benefits. These future cash flows are determined by the age structure of the plan participants and the promised benefits within the plan. The basic idea behind liability driven investing is that these future cash requirements should be matched against assets with a high probability of funding these cash flows. To be sufficiently funded, a plan should have assets that are equivalent to the present value of these discounted future cash flows.
The most conservative way to invest under this paradigm would be to buy a portfolio of US Treasury bonds that produce the required stream of investment returns. More aggressive approaches include using a mix of additional instruments including swaps and futures contracts. These derivatives allow for longer durations which are often necessary to match pension plan disbursements.
Investing for individuals is much less formulaic than pension investing. Pension plans call for strict benefits tied to wages earned whereas individuals needs are far more flexible. The gap between how much individuals need to meet their basic needs and how much they want for themselves or charitable purposes is extremely wide. Pension plans also have large sample sizes so that actuarial tables allow professionals to make accurate determinations of future benefits based on life expectancies. With individuals, it is impossible to predict how long someone will live due to randomness.
Stock prices are so depressed that that it is almost inconceivable that stocks do not outperform Treasury Notes by a wide margin over the long-term. However, the global nature of the recession within the real economy and the extreme degree of uncertainty in the markets also suggests that stock prices could be depressed for years to come.Therefore, a certain amount of portfolios should be retained in cash equivalents and very high-quality fixed-income. Five years of expected withdrawals should provide enough time for equities to rebound and produce higher returns than bonds. Assuming the return of more stable markets and normalized credit spreads in the bond markets, it may then make sense to more closely match assets and liabilities in the future, but our simple rule of thumb should work for the time being.