There is a solution
However, there is a solution, because the portfolio problem forces us to assess the longer term nature of assets and asset risks and, liabilities and liability risks and the relationship between the two.
If we look at the traditional method of structuring portfolios within a limited 1 to 3 year multi-period, it is clear that this may not be an efficient allocation of assets.
If too much of the income need is met from interest and dividends, the greater the long term allocation to assets exposed to inflationary risk and limited opportunity for capital appreciation. If only part of total liabilities is met from income, then capital will need to be transferred from equities to expenditure. If this transfer is not managed and planned for in advance and, if there is not a structure to manage this risk, it can actually increase risk, reduce return, incur additional transaction charges and place long term financial security at risk.
In fact we need to minimise risk to realisation of equities, plan in advanced of the need, reduce portfolio transaction costs and wherever possible manage the realisation of excess return.
One of the traditional solutions within portfolio management is to limit the range of income that can be supported from a portfolio to one which will reduce the risks of capital depletion. Unfortunately, this does not optimise the consumption of capital.
People do not save capital only to have their options limited to drawing interest. In particular, retired investors often need the higher expenditure up front and will often reduce expenditure later on in retirement. This requires an asset and a liability optimisation process.<![if !vml]><![endif]><![if !vml]><![endif]>
Modern portfolio theory
Modern portfolio theory lacks the liability component needed to plan and manage structure and cannot manage short term risk and return. It only has a rational within the one period model. Yet, modern portfolio theory underlies practically all modern retail portfolio construction.
THE PORTFOLIO SOLUTION
To solve the integration of the management of asset allocation relative to the size and timing of financial needs over time dilemma, we need to revisit the fundamental nature of asset risk and return over time.
From this analysis we can derive basic rules that determine the relationship between assets and liabilities over time and a framework for its management.