What I am going to write here is half of my summary of how Asset Allocation is done. Most of this will be done in the context of personal finance, because it is the most complex case, though this paradigm is sufficiently general that it can be applied to any entity.
Good asset allocation, and financial planning generally, focuses on two main questions:
- When will the cash be needed for expenses?
- What are the likely returns being offered by asset classes over the planning horizon at every period in which cash will be needed? Also, how likely are those returns?
Tonight I am writing about the first question. For institutions, there are typically two solutions — there is a spending rule for endowments, whereas for defined benefit pension plans and other types of employee benefit plans, the actuaries will sit down and estimate future cash needs, and when the needs will take place. (The same applies to financial institutions, though for institutions with short-term funding profiles, you won’t typically use actuaries, not that you couldn’t.)
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