Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors
The Journal of Wealth Managment, Vol. 7, No. 4, pp 8-34, Spring 2005
28 Pages Posted: 21 Aug 2006
In sharp contrast to the recommendations of Modern Portfolio Theory (MPT), a vast majority of investors are not well diversified. This neglect of diversification is seen across all wealth segments, including the affluent. This paper attempts to provide a solution to this "diversification paradox," by expanding the Markowitz Framework of diversifying market risk to also include the concepts of Personal Risk and Aspirational Goals.
The Wealth Allocation Framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments and human capital. The investor may choose to accept a slightly lower "average rate of return" in exchange for downside protection and upside potential. The resulting portfolios are designed to meet individual investors' needs and preferences, as well as to protect individuals from Personal, Market and Aspirational risk factors.
The Wealth Allocation Framework attempts to bring together MPT with aspects of Behavioral Finance through a single pragmatic Framework. A major conclusion of this work is that, for the individual investor, Risk Allocation should precede Asset Allocation.
Keywords: Wealth Allocation Framework, Diversification, Risk Allocation, Aspirational Risk, Markowitz, Market Risk, Personal Risk, Asset Allocation, Wealth, Risk, Investing
JEL Classification: G1, G11, G12, D10, D31, D81, D91
Suggested Citation: Suggested Citation