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How to Use the Need/Ability/Willingness Framework to Set Your Asset Allocation

For years now, many have stated that buy-and-hold investors should determine their asset allocation according to their need, ability, and willingness to take risk. This concept has become known as the need/ability/willingness (NAW) framework. But there is a lot of confusion surrounding how investors should use this concept to help them determine their asset allocation. This post is meant to provide clarity to the subject, which can be quite helpful.

First, let's define what each of these terms mean, starting with asset allocation.

An asset allocation refers to the mix of assets an investor has in his or her portfolio. Broadly speaking, most think of one's asset allocation in terms of just two assets: stocks and bonds. Clearly, there are many more assets that investors can plausibly include in their portfolios, but the main point here is that many investors need both volatile assets, like stocks, and less volatile assets, like bonds, in their portfolios. So, for discussion purposes, I'll refer to asset allocation here as the mix of stocks and bonds in one's portfolio.

Need refers to the minimum return that investors need to achieve their goals. As an example, an investor employing the so-called '4% rule' (which isn't a rule at all, but that's a topic for another day) needs about a 1.3% annual return above inflation, assuming that there is no volatility in the return.

Ability refers to the maximum level of risk investors' can take and still have a high likelihood of achieving their goals. For instance, retirees whose essential spending needs are entirely satisfied with guaranteed income sources such as Social Security benefits are generally able to take on substantial risk with their investment portfolios. Conversely, retirees whose essential spending needs require them to withdraw 4% of the starting balance of their

Willingness refers to the amount of uncertainty investors are prepared, both emotionally and cognitively, to take on to achieve their goals. This is frequently referred to as investors' risk tolerance.

Now that we know what these terms mean, let's see how we can use them to help us derive an investment strategy.

From an objective (i.e., rational, non-emotional) perspective, there is a range of potential asset allocations that investors can choose from. The NAW framework helps us to determine both what this range is and which asset allocation is likely the best for an investor.

Double Arch, Arches National Park

Thinking of this in terms of what percentage of an investor's portfolio is in stocks, the lower bound value of this percentage is represented by the investor's need; the investor needs at least this percentage of the portfolio to be in stocks.

The upper bound value of the asset allocation is represented by the investor's ability; the investor cannot prudently allocate more than this percentage of the portfolio to be in stocks.

With lower and upper bounds of the potential range of acceptable stock allocations specified, the investor now selects a specific stock allocation within this range that matches as closely as possible to his or her willingness to take on risk.

For instance, if the investor needs at least a 30% allocation to stocks, has an ability to take on a 90% allocation to stocks, and is willing to take on a 50% stock allocation, then the 50% stock allocation is selected.

But what if the investor's willingness to take on risk is below the investor's need? For instance, what if an investor needs a 40% stock allocation, but the investor is only willing to take on a 25% stock allocation? This is a real problem as the investor's goals are unlikely to be met, but there are paths to a resolution. Perhaps the investors' spending needs can be reduced, which would, in turn, reduce the need for a higher stock allocation.

The need for a higher stock allocation can also be reduced by delaying Social Security benefits and/or by purchasing a SPIA, which guarantees a certain amount of income for the remainder of one's life. Note that I highly recommend that an annual cost-of-living adjustment of at least 2%, and preferably higher, be purchased with a SPIA.

And investors should know that their willingness to take on risk is not 'fixed'. For instance, it can be increased through financial education and by reducing one's income uncertainty, which the purchase of a SPIA can also accomplish.

Those familiar with the NAW concept may have heard someone say something like "In general, I recommend choosing the lowest equity allocation derived from the three tests (ability, willingness and need)," but this is problematic for several reasons. It makes no sense for an investor to take on less risk than they truly need to simply because their willingness is below their need; as noted above, there are steps that can be taken to mitigate this issue. And if investors are both able and willing to take on more risk than is strictly necessary, there is no compelling reason for them to not take that risk, even if they don't need to. Perhaps they are investing in part for those who will be left behind after they go, such as their heirs and/or charity. Finally, an investor's ability to take on risk can never be lower than their need, so including ability in the framework is nonsensical if the investor always selected the most conservative asset allocation suggested among the three variables.

Putting actual stock allocations isn't a very straightforward proposition, but there are some tools available to help investors understand this. For those still in accumulation, Tyler at Portfolio Charts has an excellent post on his site explaining how to easily determine what saving rate was historically needed to achieve target portfolio value over a given period of time for different portfolios. Also at his site is a fantastic tool that can be used to evaluate the historic success of a retirement spending strategy for different portfolios. These tools can be used to help investors determine what their need and ability to take risk are. Investors can use risk tolerance questionnaires to help them start to get a rough idea of their willingness to take on risk, but these should be used with care.

It's vital for investors to take on an amount of risk that is fitting for their own situation and unique characteristics, including their own tolerance for risk, to help them reach their investment goals. If used well, the NAW framework can help investors do this. Also, this is definitely not a 'one and done' proposition. Investors should periodically review their situation to see how things have changed and whether they need to increase or decrease the risk they are taking on.

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