For some investors, risk tolerance changes with increases or decreases in their level of wealth. However, many investment policies mandate a constant proportional weighting between stocks and bonds during both bull and bear markets. A fixed investment allocation is usually termed a “Constant Mix” asset management approach. Such an approach is defensible under a variety of commonly held assumptions; and, is often recommended as a reasonable alternative to the risks of market timing. Advisors advocating that investors “stay the course” during perilous market conditions implicitly assume that investors, in general, benefit from a Constant Mix approach.

Financial economists, however, have long recognized that investment “rules of thumb” may change dramatically in the presence of labor income, age, health status, illiquid projects (home ownership), closely held business assets, and ongoing consumption objectives (retirement income). Investors are not a homogeneous group; and, for some investors, changes in wealth may cause corresponding changes in risk tolerance. Wealth management, therefore, may require dynamic changes in asset allocation as well as in other aspects of investment policy.

My most recent article outlines several asset management approaches and discusses the importance of aligning the approach with investor risk preferences. If the investment policy ignores this critical “calibration,” there is little hope that the investor will be able to maintain the policy during recessionary periods. It presents an added simulation study to illustrate the range of possible portfolio evolutions under each approach. Finally, it focuses on how investment advisors can transition from static to dynamic investment policy by using advanced simulation tools and by transforming set-in-stone asset management guidelines into a sequence of periodic decisions regarding the exercise of asset management options.

Dynamic IPS Paper