A variety of investment approaches
Every investor works with an investment model, ranging from approaches without a formal system to very sophisticated and complex models. The traditional asset allocation model is often the starting point for a personal model, although its use is usually more theoretical than practical. Other models, such as the Black-Littermann models or the Norwegian approach, are excellent sources of inspiration. As a serious investor, you should also consider developing and adopting an investment model tailored to your needs, even though it is likely to evolve over time. For example, many pension funds started with the standard model in the 1990s.Then, they moved to the Yale model in the 2000s based on its initial success, and have added the factor approach since 2020.
All asset owners have spending needs of some level. The more contractual these needs are, the more they become binding commitments and the more they need to be built into the model. Conversely, asset-based investment models, such as those for younger investors without significant liabilities, benefit from a wider range of opportunities to invest in risky assets, including equities and alternative assets.
Key components of an investment model
As an investor, you should consider the following key components in your situation, which will form the basis of your investment model:
- The balance between assets and liabilities: This requires you to consider the amounts and duration of your investments and your liabilities;
- Risk management: You will limit your risk mainly by diversifying the portfolio and defining an acceptable level of risk; you will need to consider how much risk you are willing to take and under what circumstances in order to assess your risk aversion and translate it into a risk appetite statement;
- Generating an appropriate return on investment;
- Managing costs: You will mainly use low-cost brokers and ETFs to do this (here are some practical options).
After assessing the key elements of an investment model, it is worth thinking about the consequences in order to refine it: is your risk appetite consistent, what is your view on illiquid assets, what would be your minimum or maximum rebalancing during the most difficult times? It is essential to make explicit the assumptions underlying your choice of components in order to derive your consequent model.
Limitations of investment models
There are some limitations of standard models to consider. Some theoretical models are very complex and largely inapplicable. Others are theoretically sound but have practical problems and are difficult to implement in their original form, such as risk parity. We recommend the transparency and passive investment of the Norwegian model, but no one has its size constraints. On the other hand, an individual can adapt a passive core approach to his or her particular situation. The endowment model also uses alternative asset strategies and active selection that is difficult for individual investors to emulate. The endowment model and the factor allocation model apply new technological advances and can be a source of inspiration for long-term investors, but these technical innovations are often out of reach for individual investors.
Key takeaways for private investors
If you do not want to spend too much time with portfolio management theory, remember that the basic rules of the markets will hold true beyond any investment model: the importance of diversification, mean reversion of returns over the long term, and the difficulty of creating alpha in public markets.
The weighting of private assets will depend on your individual situation, but you should avoid too much concentration on a single illiquid asset (which can be difficult with real estate). Passive investing (Norwegian model) remains the best approach because of its diversification and limited availability of alpha. The choice of the strategic asset allocation is then essential: The hypothesis of returns (Capital Market Expectations) are the key starting points in order to anticipate the average reversion of the returns. Numerous studies have shown that the choice of strategic portfolio (asset allocation and resulting benchmarks – see asset allocation implementation) explains most of the variability of returns, so do not underestimate the consequence of this choice and evaluate your strategic asset allocation carefully!
Source: New Perspective on Investment Models, The Journal of Portfolio Management, Investment Models 2021, Kees Koedijk and Alfred Slager