Merrill Lynch Global Private Clients has produced a report called “Wealth Allocation Framework” to understand risk allocation as it applies ...

Merrill Lynch Global Private Clients has produced a report called “Wealth Allocation Framework” to understand risk allocation as it applies to personal investors, in the same way that asset allocation is understood within modern portfolio theory. Modern portfolio theory recommends that investors’ portfolios be diversified, however many wealthy investors have seen their assets grow substantially despite the fact that their portfolios have remained un-diversified, creating a paradoxical situation. The dangers of not being well diversified were made painfully clear to many investors, who showed "irrational exuberance" at the time of the internet bubble, said the Merrill report. Of the minority of wealthy investors who seem to have defied the need to diversify, some have enjoyed undiversified success with real estate, among other examples. The Wealth Allocation Framework leads from the premises that the risk-return preferences of individual investors are different from those of the markets, and to address this, the paper introduces the concept of risk allocation. Risk is broken down into components: personal risk, aspirational risk and market risk, to consider individual’s risk allocation as a priority over and above asset allocation. Personal risk is the desire to avoid or reduce losses that could jeopardize the standard of living; aspirational risk is a desire to enhance lifestyle and meet aspirational goals; while standard market risk accords to what is already understood within modern portfolio theory. It also incorporates all of an investor's assets and liabilities, including home, mortgage, and human capital, as opposed to just financial assets, to broaden the concept of risk beyond market volatility. Ashvin Chhabra, managing director and head of wealth strategies and analytics at Merrill Lynch GPC, and the author of the framework, said: “There has been renewed emphasis on educating investors about the benefits of portfolio diversification. "But, five decades after Harry Markowitz’s pioneering work outlined the foundations of Modern Portfolio Theory, most individual investors are not diversified. Traditionally this lack of diversification has been dismissed as ‘a deviation from rational investing'.” The framework aims to allow for the optimum allocation of risk, including the budgeting of one's resources, among the personal, market, and aspirational risk dimensions, to meet those goals while still benefiting from efficient markets. “In order to achieve an appropriate allocation of wealth for the individual investor, risk allocation must precede asset allocation,” he said.