How much cash do you have in your portfolio? While conventional wisdom suggests limiting the size of your cash position, a recent study from Dalbar calls for holding enough cash and cash equivalents to cover five years’ worth of expenses.
Under the firm’s Prudent Asset Allocation model, the rest of your assets should be invested in growth assets to capitalize on the historical trajectory of the stock market. The Massachusetts-based financial services firm argues Prudent Asset Allocation outperforms asset allocations based on an investor’s risk tolerance. For help designing an appropriate asset allocation and managing your portfolio, consider working with a financial advisor.
What is Prudent Asset Allocation?
Dalbar’s Prudent Asset Allocation (PAA) strategy separates an investor’s assets into two different categories: preservative assets and growth assets.
In Dalbar’s estimation, the assets most suitable for preservation are Treasury bills, 10-year Treasuries as well as guaranteed annuities and FDIC-insured bank deposits. The firm examined historical stock market data and found there were eight years between 1940 and 2021 in which the S&P 500 fell by 10.5% or more. But all eight of these declines, which Dalbar calls “shock losses,” were followed by 100% recoveries within five years. In fact, the median recovery time was 2.5 years, the firm noted.
“If waiting for recovery is not feasible, then sufficient funds should be held in Preservative assets,” the study suggests.
As a result, investors following Dalbar’s PAA model may keep up to five years’ worth of expenses in preservative assets like Treasuries and money market accounts. If the investor is still working, his or her income can be paired with these preservative assets to cover immediate financial needs in the event of a market downturn.
An investor’s growth class is the second category of assets deployed within the PAA strategy. The firm points to S&P 500 and Nasdaq equity investments as the best growth assets, considering their record of “superior returns” and consistent recoveries following market dips.
Between 1928 and 2021, the median 10-year return of the S&P 500 and Nasdaq were 156.4% and 190.3%, respectively, according to Dalbar. Meanwhile, both indexes showed a track record of recovering from shock losses within five years of the downturn.
The PAA strategy is intended to deplete the preservation class of assets at a rate that’s slower than the long-term growth of the growth category. “When market conditions are favorable, Growth assets are used to replenish the Preservative class,” Dalbar says. “This process protects investors from shocks to the Preservative class while benefiting from the long term returns of the Growth class.”
Prudent Asset Allocation vs. ‘Arbitrary Asset Allocation’
Dalbar distinguishes its brand of asset allocation from what’s typically employed by investors and financial advisors alike, which it calls “Arbitrary Asset Allocation” (AAA). While AAA relies on fixed allocations within asset classes and periodic rebalancing, the firm says its PAA model “sets allocations based on the market’s historical ability to recover from severe declines.” As a result, PAA portfolios don’t need to be rebalanced.
Is it better, though? Dalbar tested the AAA strategy against PAA by examining how a target-date fund split 60/40 between equities and bonds would have fared against a PAA portfolio between 2001 and 2020. The study determined that the PAA strategy outperformed AAA in both one-year returns (23.78% to 15.58%) and 10-year returns (98.62% to 60.94%) during that time period.
Furthermore, the firm asserts that investors forfeit nearly 38% of their returns “in an attempt to limit temporary losses while failing to protect essential short term funds.”
Bottom Line
Unlike traditional asset allocation strategies, Dalbar’s Prudent Asset Allocation model does not aim to meet target allocations within asset classes. Instead, it seeks to split assets between preservative and growth categories in order to cover any short-term financial needs an investor may encounter in the next five years, and at the same time, take advantage of the stock market’s historical record of growth.
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