Detailed Methodology | Allocatewise

IMPORTANT INFORMATION

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Detailed Methodology - Challenge - Solution

Saving money to live from later in life ("retirement") is different from general investing. In general investing the benchmark is the risk-free rate paid by governments on their debt. When saving for retirement, the benchmark is the increase in the future cost of living. For simplicity this can be assumed to be inflation - usually expressed as the Consumper Price Index (or CPI). Of course, it is debatable if one's personal consumption costs increase with inflation. But without better alternatives for measuring inflation, using CPI or RPI (in the UK) is better than nothing at all. In addition, nobody knows what their future cost of living will be. The best we can do is to consider current prices for things and extrapolate with inflation.

Looking at retirement savings with consideration to inflation does not only tend to increase the return that is required to exceed the benchmark. It changes the whole equation!

What matters is the performance against the goal of maintaining a good standard of living, as measured by the portfolio's performance against the CPI.

Illustration of the reduction in purchasing power. Since 2005 purchasing power of a Dollar fell by 40% to 60% of it's original value.

Annualised Monthly returns and volatility for different asset types, along with their real returns and correlation of both Nominal and Real Return with US CPI.

Using inflation as a benchmark for retirement savings

In practice, it means that all returns of assets will be measured against inflation.

The table displays the return of these broad ETFs adjusted by the US CPI All Urban Consumer price index. Historical returns are not an indication of the future, but the table demonstrates the potential issue when looking at long-term growth rates of portfolios. Without considering the increase in the cost of living, they are not very informative. Furthermore, apart from commodities, no assets exhibit positive correlation with inflation.

Assets moving with inflation

Some assets are traditionally seen as providing some security against inflation (for example real estate investments). While they share similar trends with inflation, the direct correlation of real estate and inflation is historically relatively small. The same is true for commodities. Assets which tend to correlate with inflation have historically exhibited poor returns (for example, cash or commodities).

Correlation Matrix of different asset classes vs CPI, for Monthly, Yearly and 5-yearly data

Starting with the real yield

Performance of inflation-linked bonds is historically not closely correlated with inflation, nor have they shown significant outperformance against inflation. But they provide a very important function: They define what yield above inflation can be achieved at any given point, by taking only marginal risks. Specifically the central government's default and a small reinvestment risk.

Their yield-to-maturity (YTM) above inflation provides a benchmark against all other investment opportunities can be measured. The "real yield".
The UK has continously issued inflation linked bonds with varying maturity. Using the real yield on these linkers a continous real yield curve can be built. In the EUR zone, Germany and France have issued "linkers". For investments in USD a well establisehd US TIPS market provides the real yield curve.

Mapping the real yield of the inflation linked bonds to their maturity dates creates the real yield curve.

Real Yield Curve, demonstrating expected real risk-free annualised returns over the next 50 years

Inflation linked bond payout strucutre

Establishing a baseline

Historically, the real yield available in the market has varied considerably and often has been negative. The current real yield curve provides the "risk-free" rate in the portfolio construction.

s to receive 1,000 GBP in 2040 uplifted by inflation, they can buy the inflation link bond expirying that year and be pretty certain that they will receive the redemption amount in 2040, which incorporates compensation for the inflation experienced in the meantime.

It is important to note that this is only true if the inflation bond is held to maturity!

The efficient frontier graph

Assessing investments vs. real yield

In efficient markets risk is on average compensated by increased returns. Therefore an investment portfolio should have some risk. But the question is how much and in which assets an investor should invest.

Since the introduction of portfolio theory in the 1960s, it is a well known concept to create an "efficient frontier" - meaning the combination of assets which is expected to have the least variation in returns given a specific return. The allocatewise.com App uses this concept based on historical correlation and returns - or user-based inputs - to calculate an efficient frontier relative to inflation. The software solves for the minimum variance portfolio given a return and the selection of asset classes, as well as the historically observed features of asset classes.

Mixture of 'risk-free' real yield and risky portfolio

The actual allocation in a retirement portfolio should depend on each individuals' risk appetite and 'utility function' i.e. how much additional return someone needs to receive in order to take on additional risk.

Each portfolio is a combination of "risk-free" and risky portfolio i.e. a inflation-linked portfolio and a portfolio based on the asset selection and covariance inputs. How much each individual investor invests into the risky and the risk-free portfolio is guided by their preference and risk tolerance. allocatewise.com only provides indications on which combinations may be attractive to investors. There is some academic guidance around it and you are invited to research relevant concepts. For example the Merton Share or the Kelly Criterion .

You may also use the risk slider in our app to get a feel for the sensitivity of allocations to risk appetite.

Visualization of allocatewise portfolio construction methods using risk-free and risky portfolio mixture