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The celebration of 10 years of The Journal of Wealth Management has provided us with an opportune occasion to write a short review of our two-decade-long journey in creating wealth allocation analytics and frameworks. Many of these innovations have stood the test of time and much of what we describe here is still in use at our former firms.1,2 Much further work in these areas remains to be done and we hope that the lessons learned in this journey will serve as a guide to anyone seeking to create his or her own wealth allocation process.
Appropriately, the initial spark for this journey was created by none other than the current editor of the JWM - Jean Brunei.3
FROM MARKOWITZ TO MONTE CARLO4
In the early 1990s, the state-of-the-art in asset allocation was pre-tax mean-variance optimization, based on Dr. Harry Markowitz 's groundbreaking work in the 1950s. The best advisers for wealthy individuals at the time tended to be mostly in two camps-those that focused on stock picking with a sufficient allocation to munis for income and those that emphasized asset allocation and diversification by applying mean- variance optimization. In a typical implementation of Markowitz' framework, the application sought to find the highest returning mix of assets for a given level of risk (or vice versa). Inputs to the tools were usually historical assumptions for the mean, variance, and correlation of each asset class, and the underlying asset returns were approximated by a normal distribution. This implementation had important limitations for individual investors: no taxes, no transaction costs to move to the optimal portfolio or rebalancing, no cash flows or time dimension (single period). Financial planning applications added detailed future expenses and returns, but they used point estimates. All of these applications suffered from a common flaw, in that more-aggressive asset allocations (more equity) showed higher estimated rates of returns without a clear mechanism to emphasize the possible impact of the additional risk incurred, other than an increased portfolio volatility number. Thus, in cases of projected cash shortfalls (not saving enough for retirement), the natural mechanism to solve the issue (without reducing spending) was to move to a more-aggressive asset allocation.
As is also evidenced today, two groups were at the forefront of exploring...