Thought Leadership Wharton Thought Leadership in the COVID-19 Era Wharton Ready Livecast Series Wharton Livecast COVID-19 and the Markets Wharton Livecast Building Smarter Supply Chains Wharton Livecast Financial Management in the Crisis and Beyond Wharton@Work Wharton Wealth Management Initiative Wharton Wealth Management Thought Leadership Active vs. Passive Investing: Which Approach Offers Better Returns? Why Asset-Allocation Decisions Are Complex – and What to Do About It Wharton Wealth Management Initiative Academic Director Wharton School Press Research Centers for Interdisciplinary Study Why Asset-Allocation Decisions Are Complex — and What to Do About It Asset allocation — the mix of different investment classes in a portfolio — is the single most important factor governing returns. And the Internet is full of calculators to help investors find the best combination of stocks, bonds and cash. But a well-to-do individual or family needs a deeper look at the asset-allocation decision, according to faculty members in Wharton’s Wealth Management Initiative. Markets don’t always follow past patterns, and high net worth investors have concerns that small investors do not. Among the key issues: How to account for substantial wealth tied up in a business How to adjust for an investing time horizon that can last for generations How to use hedge funds, private equity, and other alternative investments to manage risks and maximize returns. Finding the Right Mix The answers to many of these questions impact the asset allocation decision. While small investors can start simply, relying on the classic do-it-yourself split — 60% stocks, 40% bonds — high net worth families typically require a team composed of wealth managers, lawyers, estate planners, and, if the family owns a business, its managers as well, says Christopher C. Geczy, Wharton adjunct professor of finance and academic director of the Wharton Wealth Management Initiative. “In some cases, folks of means are really thinking of themselves as stewards of capital, not just owners of capital,” Geczy explains. Wealth of this type is managed not just to last through retirement, but to serve future generations and philanthropy as well. As priorities vary, two families of equal wealth might therefore come to very different conclusions about how much to put into each type of holding, he says. One family might choose a conservative approach to produce steady income, while the other might take more risk in hopes of maximizing growth. Wharton finance professor Jeremy Siegel says the principles behind asset allocation are straightforward: Historically, stocks have produced higher returns over the long term than bonds or cash, but with larger swings up and down. Young investors therefore emphasize stocks for growth, older ones bonds and cash for safety. But one period can be very different from the next. Wharton finance professor Richard Marston notes that stock returns plummeted from 2001 through 2012, while bonds did exceptionally well. That’s a very long period to live with out-of-the-ordinary results. To make matters even trickier, assets such as different types of stocks and bonds that once marched to different drummers are now more likely to move in tandem, adds Kent Smetters, professor of business economics at Wharton. The cause appears to be globalization and computerization of financial markets. The result: reduced benefits from diversification, the keystone of asset allocation. That’s why the market’s potential for change must be part of the asset allocation decision. Alternative Investments For well-to-do investors, other types of assets also come to play. These can include alternative investments like hedge funds, private equity, and derivatives – which can be used to help minimize risk or maximize return – as well as some new options that don’t fit easily into the traditional asset allocation model. “We see a huge increase in what we call ‘principal investments,’ where the family, possibly in collaboration with another family, makes a direct investment in a private company,” says Raffi Amit, the Robert B. Goergen Professor of entrepreneurship and a Professor of Management at Wharton. In many cases, these investments replace allocations to private equity funds, as many high net worth investors now prefer to manage investments in-house to gain control and minimize fees. But the risk-versus-return analysis of a privately-held company is very different from a basket of stocks and bonds, making professional asset allocation advice essential for investors who venture outside the mainstream, Wharton faculty say. Alternative investments such as hedge funds and private equity can have a dramatic effect on the asset allocation decision, because these holdings are not as liquid as stocks and bonds. With a lot of money tied up in alternative investments, an investor might be wise to reduce risk in the liquid portfolio. But due to some of the complexity of using alternative investments, Siegel cautions against too much reliance on them because of their high fees and restrictions on withdrawals. Finally, the asset allocation of a liquid portfolio should be adjusted to account for the investor’s risk with an illiquid asset such as a family-owned company — an issue that too many family offices overlook, says Smetters. “Family offices really do not have very strong processes when it comes to thinking about risk management,” he says. The asset allocation decision, Geczy concludes, can be an extremely complex process for investors of means. It takes constant monitoring by a team of experts ready to adjust as conditions change.