From Diversification to Categorization

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In 1,5+ years of Cape May Wealth Weekly, the Aspirational Investor Framework continues to be the most widely adopted piece of ‘knowledge’ that I have written about. Whether it’s college students, affluent investors, or even family offices - I am always happy to meet someone who found out about the Framework through my writing and has decided to implement it for themselves. Through the many, many conversations with ‘practioners’ of the Framework, as well as implementing the Framework firsthand in our financial planning process, I’ve seen a number of common questions that arise in action. 

One such question revolves around income requirements, specifically, to which Bucket an investor should look to plan for their their long-term lifestyle expenses. (In our view, that’s the Market Bucket, with the exception of large fortunes, where one can even consider setting up a designated ‘Income Bucket’. More on the matter in Adressing Your Income Requirements.)

Today, we want to address another question, perhaps the most frequent one: The question of categorization, meaning the question of which Bucket each asset class should fit into.

Unsurprisingly, client preferences and experiences differ greatly. Hence, one wouldn’t be surprised if one investor might categorize an asset class into one Bucket, while another one might put it into another Bucket. And that is true, to a degree. But personal preference doesn’t have to be the deciding factor. In our view, it should be question of actual and desired diversification.

Intermission: The Aspirational Investor Framework

If you happen to be a new subscriber, let me give you a quick recap of what we are talking about.

When I started out as an independent wealth advisor in 2023, I was searching for an approach to asset allocation that would fit my personal experiences and preferences. In my view, the quantitative models championed by banks had proven to be too theoretical, static and inflexible - while they were great at measuring expected risk and return, they struggled with simple challenges such as clearly aligning with a client’s Investment Objectives, or even their individual short-term goals.

But luckily, I stumbled across the Aspirational Investor Framework - and have championed it ever since. It was pioneered by former Merrill Lynch Wealth Management CIO Ashvin Chhabra, who believed the asset management industry’s focus on indexing and ideal benchmarks didn’t respond to the realities of a personal life. Individuals don’t want to invest for the sake of a financial return: They seek to generate returns so that they can pay for their kids’ educations, protect themselves in an unexpected crisis, and fulfill their personal dreams and desires.

As Chhabra explains in The Aspirational Investor (a book which, unsurprisingly for frequent readers, I highly recommend), the framework incorporates “three seemingly incompatible objectives […]: the need for financial security in the face of unknowable risks, the desire to maintain current living standards despite inflation, and the opportunity for life-changing wealth creation.” Exactly what most of our clients are looking for.

For a deep dive into the Aspirational Investor Framework, check out my article here, or simply get the book and read it for yourself.

Different Tastes, Different Buckets

By nature, the Aspirational Investor Framework is a goals-based investing approach, matching a specific goal (i.e. a need for a safety buffer for emergencies) with a certain amount of certain assets (like a 250K€ safety buffer, or Notgroschen). While that sounds easy in practice, it faces challenges when we try to translate this goals-based approach into a client-specific asset allocation. More precisely, there are two challenges that we often encounter:

One, perhaps driven by how we use the Framework, certain assets might appear more than twice. For example, liquidity might appear in the Safety Bucket, but also in the Market Bucket as cash earmarked for capital calls. Public equities might show up in the Market Bucket when invested in a diversified portfolio, but might also be part of the Aspirational Bucket in the case of a concentrated single-stock position.

Two, and as already mentioned before, there are frequent questions around how to categorize certain assets. Take one of the most common asset classes in the portfolio of our clients, venture capital: While direct venture investments are generally seen as ‘Aspirational’ assets, opinions differ on venture funds. We’d expect a good venture fund (hopefully) to have only a very small chance of facing a total loss of capital - but many clients see venture as a generally risky asset class, and hence would see their venture fund as an ‘Aspirational’ asset, sometimes even grouping them together with direct investments.

Then, there’s cases like crypto. While we continue to be cautiously curious about crypto, we are still cautious given the comparably short track record (~15-16 years for Bitcoin, compared to 100+ years for other conventional asset classes) and the underlying security risks (losing access to your cryptocurrencies due to a hack or a simple loss of a password). Hence, we’d clearly categorized as an ‘Aspirational’ asset. (Read more in Crypto from the Multi-Asset Perspective.) But some clients disagree: For one client, Bitcoin had become an established currency, which is why he’d asked us to allocate his Bitcoin investments to his Market Bucket. The prospect of technological adoption of Blockchain technology as a whole had him consider whether all liquid token investments should be added to that as well. (Interestingly enough, despite a somewhat diversified portfolio, he had agreed with our notion of seeing his venture funds as part of the Market Bucket, instead grouping them with direct investments in the Aspirational Bucket.)

While there’ve been a few cases where I argued with clients for or against a different category (mostly from my typical standpoint of conservative, overly careful financial advisor), I’ve found it best to simply reflect a client’s personal preferences in how they want their portfolio to fit their personal preferences. But the question does remain - is there a general framework that we can use to assess whether an asset class should or shouldn’t be in a certain Bucket?

We think there is.

At Cape May Wealth Advisors, we’ve worked with numerous clients in successfully implementing the Aspirational Investor Framework in the context of their wealth and their individual goals. Thanks to the Framework, we’ve found solutions to challenging client problems, ranging from correctly sizing a diversified, income-oriented portfolio, to finding the right allocation for risky venture bets, to developing a framework of impact and purpose across different portfolio building blocks.

If you are looking for a partner to help you implement the Aspirational Investor Framework in your own portfolio, don’t hesitate to reach out.

Diversification as Deciding Factor

To us, it’s a question of diversification. An asset class’ categorization should primarily depend on how the individual investor tends to access it - more precisely, the desired degree of diversification, and the resulting impact on an asset class’ risk-return-ratio.

Take the Market Bucket. All investments made here should ideally be in a diversified manner so that your expected risk-return-ratio of a given investment should not deviate substantially from the underlying asset class. For example, the equity allocation within your Market Bucket might be an ETF that tracks the underlying equity index minus costs, or might deviate moderately, but not substantially, if you chose to go with an active manager. Even if you have appetite for concentrated, high-risk managers (as many investors following the endowment approach do), a diversified portfolio of such managers would also fit our diversification requirement.

Moving on to the Aspirational Bucket, we see the opposite, i.e. a lack of diversification, as deciding factor. Let’s stay with public equities: If you don’t have a diversified portfolio of ETFs, but just a small, concentrated portfolio of stocks, there are arguments to be made for that portfolio to be placed in the Aspirational Bucket and not the Market Bucket. Things become even clearer for a portfolio of individual ‘bets’ in single stocks or derivatives (a ‘Zockerdepot’ as we like to call it in German). And things are very clear in the case of a concentrated single stock position, whether gained through investment, a distribution from a fund, or perhaps even a company you took public yourself.

And that same logic can be extended to most asset classes:

• If you have a diversified portfolio of bonds, it’s likely right to be placed in the Market Bucket (or maybe even the Safety Bucket depending on its purpose). A handful of risky, tactical bond bets? Aspirational Bucket.
  

• A single fund, whether it’s private equity, venture capital or real estate? Highly concentrated, and subject to binary risk factors such as manager risk, and thus correctly placed in the Aspirational Bucket. On the other hand, a diversified portfolio of funds (think your self-sustaining fund portfolio that breaks even after a couple of years), even for individually risky funds, might be correctly placed in the Market Bucket.
  

• A handful of direct venture investments, ranging from pre-seed to pre-IPO? If there’s no clear logic and insufficient diversification (think 50+ investments), you should definitely see it as part of your Aspirational Bucket. But if you’re really a very active angel investor with a widely diversified and thought-through portfolio (think 100+ bets that ensure that you’re very likely to at least return your invested capital even in a worst case scenario), you could see it as part of your Market Bucket. Admittedly we’ve yet to meet a client that fulfills these requirements - most tend to then divide the capital into Market and Income Bucket, as mentioned in Adressing Your Income Requirements.

Admittedly, there’s one exception that we’d make - and that’s in real estate. First, private real estate: While a single private residence clearly does not fulfill a diversification requirement, it is a typically a substantial hedge for clients in regards to their long-term costs of residence. Since we also clearly categorize that into the Safety Bucket, we also avoid the common mistake of expecting the personal residence to contribute to long-term capital requirements. Secondly, investment real estate: A portfolio of 2-3 properties, often all within one city, does technically not fulfill the diversification requirement either. However, when it comes to investment real estate, most clients are somewhat careful, meaning they aim to acquire Buy & Hold-oriented properties, take reasonable amounts of leverage, and try not to speculate along the way. (They also typically have insurance in place to hedge against events that would cause a total loss of invested capital.) Lastly, given the ‘hard asset’ aspect of both private and investment real estate and its expected resilience against inflation, we think the case can be argued that either don’t belong in the Aspirational Bucket.

Despite this little flaw in our argument, we think diversification can, and should, be the deciding factor, in deciding how certain asset classes should be categorized in your personalized implementation of the Aspirational Investor Framework. Also don’t forget that there’s nothing wrong with asset classes showing up more than once: After all, the Framework is a goal-oriented approach, and there’s no rule against reusing simple building blocks such as cash or bonds across different goals. For a higher level of detail (approaching the logic of an strategic asset allocation), you can even differentiate between different types of implementation in an asset class, like a diversified ETF portfolio in the Market Bucket and a handful of single stock bets in the Aspirational Bucket.

Despite our preference for the diversification-driven categorization, personal preference is still a factor at play. In the end, asset allocation decisions are rarely black and white, but more often gray. So what if you are still on the fence about an asset class, diversified or not? We think that a final indicator can be your ‘gut feeling’ on what role an investment is supposed to play in your overall portfolio.

Did you make the 4-5 venture fund investments because you are looking to venture as a building block in the portfolio fulfilling your long-term income requirement? Then the Market Bucket can be right. But if your gut feeling tells you they were more opportunistic bets, perhaps also to get access to skilled investors and innovative start-ups, then the Aspirational Bucket might be a better fit.

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