Modern Asset Allocation for Wealth Management

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