Modern Asset Allocation for Wealth Management

An authoritative resource for the wealth management industry that bridges the gap between modern perspectives on asset allocation and practical implementation

An advanced yet practical dive into the world of asset allocation, Modern Asset Allocation for Wealth Management provides the knowledge financial advisors and their robo-advisor counterparts need to reclaim ownership of the asset allocation component of their fiduciary responsibility. Wealth management practitioners are commonly taught the traditional mean-variance approach in CFA and similar curricula, a method with increasingly limited applicability given the evolution of investment products and our understanding of real-world client preferences. Additionally, financial advisors and researchers typically receive little to no training on how to implement a robust asset allocation framework, a conceptually simple yet practically very challenging task. This timely book offers professional wealth managers and researchers an up-to-date and implementable toolset for managing client portfolios.

The information presented in this book far exceeds the basic models and heuristics most commonly used today, presenting advances in asset allocation that have been isolated to academic and institutional portfolio management settings until now, while simultaneously providing a clear framework that advisors can immediately deploy. This rigorous manuscript covers all aspects of creating client portfolios: setting client risk preferences, deciding which assets to include in the portfolio mix, forecasting future asset performance, and running an optimization to set a final allocation. An important resource for all wealth management fiduciaries, this book enables readers to:

• Implement a rigorous yet streamlined asset allocation framework that they can stand behind with conviction
• Deploy both neo-classical and behavioral elements of client preferences to more accurately establish a client risk profile
• Incorporate client financial goals into the asset allocation process systematically and precisely with a simple balance sheet model
• Create a systematic framework for justifying which assets should be included in client portfolios
• Build capital market assumptions from historical data via a statistically sound and intuitive process
• Run optimization methods that respect complex client preferences and real-world asset characteristics

Modern Asset Allocation for Wealth Management is ideal for practicing financial advisors and researchers in both traditional and robo-advisor settings, as well as advanced undergraduate and graduate courses on asset allocation.

Preface vii

Acknowledgments xiii

Chapter 1 Preliminaries 1

Expected Utility 2

Introduction 2

MPT is an Approximation 5

Higher Moment Motivation 8

Modernized Preference Motivation 13

A Modern Utility Function 15

Returns-Based EU Maximization 21

Estimation Error 23

Introduction 23

Minimizing Estimation Error 24

Reducing Sensitivity to Estimation Error 28

A Modern Definition of Asset Allocation 30

Chapter 2 The Client Risk Profile 33

Introduction 33

Measuring Preferences 34

Risk Aversion 34

Loss Aversion 39

Reflection 41

Lottery Question Sizing 43

Incorporating Goals 43

Preference Moderation via SLR 43

Discretionary Wealth 48

Comparison with Monte Carlo 51

Comparison with Glidepaths 52

Chapter 3 Asset Selection 55

Introduction 55

Moment Contributions 57

Overview 57

Calculation 59

Utility Contribution 62

Mimicking Portfolios 63

A New Asset Class Paradigm 66

Overview 66

A Review of Risk Premia 67

From Assets to Asset Classes 73

Chapter 4 Capital Market Assumptions 79

Introduction 79

Using History as Our Forecast 81

Background 81

Estimation Error and Sample Size 83

Stationarity: Does History Repeat? 89

Adjusting Forecasts 91

Pre-Tax Adjustments 91

Post-Tax Adjustments 93

Chapter 5 Portfolio Optimization 97

Introduction 97

Optimization Results 98

To MPT or Not to MPT? 103

Asset Allocation Sensitivity 105

Final Remarks 109

Bibliography 111

Index 113

DAVID M. BERNS, PHD, is the Chief Investment Officer and cofounder of Simplify ETFs where he leads the development of novel investment strategies that help advisors produce better outcomes for their clients. David began his finance career at a $5 billion multi-family office where he developed cutting-edge asset allocation, portfolio management, and risk management systems for managing private and institutional wealth across both liquid and illiquid asset classes. David then pivoted to developing short- and intermediate-term investment strategies that, once layered on top of a client's long-term strategic asset allocation, improve both return and risk metrics. David is also the founder and inventor of Portfolio Designer, a cloud-based asset allocation platform empowering advisors to reclaim the asset allocation component of their fiduciary responsibility.

David has a PhD in Physics from the Massachusetts Institute of Technology in the field of Quantum Computation and currently lives in New York City with his wife Carolee and son Henry.

Modern Asset Allocation for Wealth Management and the accompanying software offers advisors a guide to more accurately design portfolios for real-world client preferences while tackling the complexities of the asset allocation process. The author describes a unique framework that provides a modern yet intuitive system for creating real-world asset allocation portfolios.

The book explains in detail how to create an investment portfolio from scratch. Step by step, the author shows how to set client risk preferences, decide which assets to include in client portfolios, forecast future asset performance, and blend assets together to form optimal client portfolios. The book is organized in the order in which each asset allocation task is carried out when creating a client's portfolio in practice.

While practical in its approach, the framework presented is rigorous in its application in order to ensure a scalable process that financial advisors can rely on. The asset allocation solution presented rests on the tenets of behavioral finance and the foundations of modern financial economics. The framework also incorporates client financial goals into the asset allocation process systematically and precisely via a novel balance sheet system that is highly focused on risk management. And all tools are tied together with hyper awareness of estimation error and statistical robustness.

Rather than presenting the entire review of asset allocation tools, the author puts the focus on a limited number of tools for each step of the process. The framework outlined offers a modern yet down-to-earth process that the wealth management community can confidently deploy today.

This timely and authoritative book offers professional wealth managers and researchers the most current information and an implementable toolset for managing client portfolios.

Praise for Modern Asset Allocation for Wealth Management

"Modern Asset Allocation for Wealth Management succeeds in its ambitious goal of making asset allocation more intuitive and practical. By accounting for behavioral biases, psychometric testing, and financial goals, to name a few, David Berns enables advisors to implement asset allocation systematically with a sound scientific underpinning. This is a must read for any advisor who wants to truly understand why we invest the way we do and how best to work with clients."
—Michael Pompian, CFA, CAIA, CFP, founder and CIO, Sunpointe Investments; author of Behavioral Finance and Wealth Management

"Historically, Modern Portfolio Theory (MPT) has been an insightful—but utterly useless—tool of modern finance. David Berns flips this situation around and outlines exactly how investors can make MPT great again. I learned so much from this book. Read it."
—Wesley R. Gray, PhD, CEO, Alpha Architect; co-author of Quantitative Value and Quantitative Momentum

"David Berns has blazed a trail through the wilderness that lies between the practical challenges of wealth management and the leading edge of quantitative finance. Along the way, readers will learn innovative strategies to confront diverse investor preferences, taxes, risk premia strategies, estimation error, non-normal distributions, and many other real-world challenges. This pioneering guide is rigorous, clear, and relevant. No wealth manager should leave home without it."
—Will Kinlaw, Senior Managing Director and Head, State Street Associates; co-author of A Practitioner's Guide to Asset Allocation

"Modern Asset Allocation for Wealth Management smartly incorporates behavioral theory to improve client risk preference assessment. The realization that clients don't require the textbook version of an optimal portfolio, and that financial planners should focus on creating a portfolio that clients will stick with during down markets, is an important contribution to the advancement of wealth management."
—Michael Guillemette, PhD, CFP, Professor of Personal Financial Planning, Texas Tech University