Map your portfolio to lifestyle needs

We recently received an interesting question from a reader: How should investors map the core-satellite portfolio to their lifestyle decisions?

This article explains the three-tier lifestyle structure. It then discusses appropriate investment choices for each tier and shows how this three-tier lifestyle-investment structure morphs into a typical core-satellite portfolio.

Three-tier process


Investors typically desire a three-tier lifestyle process. The first tier is to protect the basic standard of living. The second tier is to maintain the present lifestyle. And the third tier is to enhance lifestyle. They do not construct Markowitz-efficient diversified portfolios to achieve this lifestyle process. Instead, they typically follow a tiered investment process geared towards achieving these lifestyle needs.

Take the first tier. The desire to protect the basic standard of living necessitates two financial decisions.

One, maintaining some desired level of cash for emergency purpose. And two, protecting basic cash flow to manage the household in the event of loss of income.

The portfolio constructed to meet the lifestyle needs of this tier is appropriately called protection assets, for the investor prefers asset exposure to that helps protect the basic standard of living. These assets are essentially cash equivalents and insurance contracts.

An investor has to set aside cash equal to at least three months’ expenses to meet emergency requirement such as medical expenses and/or temporary loss of income. The objective is to invest in assets that provide liquidity and carry near-zero downside risk. Money market mutual funds that invest in call money, T-bills and commercial papers should be selected, not the ones that carry exposure to short-term bonds.

The insurance contracts protect the basic standard of living by hedging mortality risk and disability risk. The risk is that the investor could die or face permanent disability. The insurance contract so purchased would provide cash flows necessary to manage the expenses following the death or disability of income-earning investor.

Lifestyle assets


The investment process that an investor has to follow to maintain the current lifestyle is called the lifestyle assets. This includes investments made for funding children’s education, buying a house and funding exotic vacation expenses.

An investor should take exposure to traditional asset classes such as stocks and bonds. The asset allocation decision would depend on the desired returns, investment horizon and the risk tolerance level of the investor.

It is important to make a distinction between investment in real estate and buying a house for self-occupation. The lifestyle portfolio helps finance the investor’s desire to maintain present lifestyle, of which buying a house for self-occupation is one. Investment in real estate, however, means buying real estate with a purpose of earning returns through rentals and/or capital appreciation.

Aspiration assets

The final tier of the investment-lifestyle process is the investor’s desire to enhance her lifestyle. The investor has to construct a portfolio that carries exposure to markets that are not yet fully exploited (exotic beta exposure). The strategy would also be to generate excess returns over a benchmark index through market timing and security selection skills (alpha returns).

The portfolio will be geared towards alternative asset classes such as commodities and alternative strategies such as private equity, market-neutral portfolios and concentrated stock portfolios. The objective is to generate higher returns to improve the lifestyle.

Conclusion


The three-tiered lifestyle structure does not require the investor to carry three separate portfolios. An investor can simply morph the various assets in each tier to form a macro portfolio. Such a comprehensive lifestyle-investment portfolio would have emergency funds for protective assets, core portfolio for lifestyle assets and satellite portfolio for aspiration assets. Investors can use a proportion of their core portfolio to purchase annuity at retirement for post-retirement lifestyle needs.