Asset dedication how to grow wealthy with next generation of asset allocation

ASSET
DEDICATION


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ASSET
DEDICATION™
How to Grow Wealthy
with the Next
Generation of
Asset Allocation
STEPHEN J. HUXLEY
J. BRENT BURNS

McGraw-Hill
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Madrid


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DOI: 10.1036/0071454675


This book is dedicated to all those people who want to
do the right thing for themselves, their families, or
their clients in managing financial investments and
who prefer to think for themselves.

The King will reply “I tell you the truth, whatever
you did for the least of these brothers of mine, you
did for me.”
—Matthew 25:40 (NIV)


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For more information about this title, click here

CONTENTS
PREFACE
ix
ACKNOWLEDGMENTS

xiii

PART 1

ASSET DEDICATION—THE NEXT STEP

IN ASSET ALLOCATION
1
CHAPTER 1

Asset Allocation—the Dominant but
Procrustean Paradigm
5
CHAPTER 2

Asset Allocation: The Gaps

20

CHAPTER 3

Asset Dedication—How It Works

33

CHAPTER 4

Asset Dedication versus Asset Allocation:
Historical Comparisons from 1926
63
PART 2

DEDICATING ASSETS BEFORE AND
AFTER RETIREMENT
93
CHAPTER 5

Calculating Your Financial Independence
CHAPTER 6

Finding Your Critical Path

115

CHAPTER 7

The Distribution Phase:
Dedicating Assets to Do Their Job

138

CHAPTER 8

Building an Asset Dedicated Portfolio:
Doing It Yourself on the Internet
155

95


viii

Contents

CHAPTER 9

Using Asset Dedication for More than
Steady Retirement Income
175
PART 3

THEORETICAL UNDERPINNINGS OF
ASSET DEDICATION:
A FEW FUNDAMENTALS
197
CHAPTER 10

Life, Death, Economics, and Time

199

CHAPTER 11

A Few Investment Fundamentals

212

CHAPTER 12

Understanding the Numbers

232

CHAPTER 13

Portfolio Management Tools

251

CHAPTER 14

Forecasting: The Good, the Bad,
and the Ugly
262
APPENDICES

1 Long-Term Bond Ratings
289
2 The Safety of Bonds Based on
Historical Default Rates
291
3 Historical Comparisons by Decade—
Middle Period (1947–1984)
297
4 Historical Comparisons by Decade—
Earliest Period (1926–1955)
300
5 IRS Rules and Regulations on Individual
Retirement Accounts (IRAs)
303
INDEX

307


PREFACE

This book is designed to shift investors and those who advise them
to a new paradigm for personal investment. Asset allocation has
reigned supreme in the marketplace of financial ideas since the
1980s. It has become such a dominant paradigm that it is no longer
possible to have a conversation about finances without hearing
something about asset allocation.
Asset allocation has had a good run, but it is beginning to
show its age. Its flaws are becoming more apparent with each passing year. The primary flaw of classic asset allocation is the lack of a
defensible way to determine the optimal formula for allocating the
funds in a portfolio to stocks, bonds, and cash. In simple terms,
classic asset allocation says, allocate X percent to stocks, Y percent
to bonds, and Z percent to cash. The problem is that there is no easy
way to determine exactly what X, Y, and Z should be.
This flaw becomes obvious if you go to three different brokers
and give them the same personal financial information. You will fill
out a “risk-tolerance” questionnaire for each broker to make the
process appear mathematically precise, but you will get three different allocation recommendations—three different formulas for
where to put your money. This should be the warning sign: Why are
the three allocations different?
If you went to three different optometrists, you would be very
puzzled if you got three different prescriptions for eyeglasses. The
formulas for correcting vision are not arbitrary. They are based primarily on the scientific laws of optical behavior. The formulas for
asset allocation, however, are not based on science. They are based
on the opinions of each broker.
Brokers and their research departments rely on asset allocation as a selling tool, hoping to make you believe that their process
is completely scientific and objective. They will point to their questionnaires and charts as evidence that they are customizing the
perfect portfolio to fit your needs. What they are really doing is
making you fit into one of their predetermined categories of
investors (“Conservative,” “Aggressive,” or whatever).
They then try to get you to sign up for their services and buy a

model portfolio that is based on a fixed XYZ percentage allocation
to stocks, bonds, and cash that is said to be best for your type of
investor. And they will tell you to rebalance your portfolio to that

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x

Preface

allocation formula in case your percentages deviate from it by more
than what the broker deems appropriate.
But if you listen carefully to their prognostications, they will
not be able to explain why their particular XYZ formula is different
from any other broker’s XYZ formula, or why it is better for you.
They can’t explain it because there is no explanation. No one has
been able to prove that a particular set of percentage values for the
XYZ formulas is optimal for any particular person. The bottom line
here is that with classic asset allocation, there is neither true optimization nor true customization of your portfolio.
It is time to take asset allocation to the next level. Asset dedication does that.
Asset dedication is based entirely on customization and mathematics. If you go to three different brokers that use asset dedication, they will give you the same prescription for how to allocate
your money, a prescription that is specifically designed to fit your
needs and your financial situation. This book explains why asset
dedication works and provides evidence of its superiority to the
asset allocation paradigm.
The idea of asset dedication is not revolutionary. It is better
described as evolutionary because it is based on the concept of dedicated portfolios, a device that is commonly used by corporations and
institutions as a financial management tool, generating precisely
timed cash flows out of large portfolios involving millions or hundreds of millions of dollars. The difference is that modern technology

now makes it feasible for small, personal investors to use the same
methods. This is especially important for retirees, who face the same
problem of generating cash flows from their portfolios. They had no
way to get access to this high-end approach—until now.
By focusing on long-term performance, asset dedication takes
advantage of the unique investment characteristics of stocks and
bonds. Each has its own fundamentally different purpose. Historically, stocks have been proven to outperform other assets for longterm growth. Bonds, on the other hand, pay a predictable income
stream and return of principal, but sacrifice long-term growth. In
asset dedication, stocks and bonds are utilized to do what each of
them does best in the precise quantities needed for an investor’s
specific situation—no more, no less. The investment portfolio flows
directly from the investor’s needs rather than fitting the investor
into a prefabricated, arbitrary investment plan.
It has been suggested that many brokers will not like asset dedication because it cuts out excessive transactions that generate com-


Preface

xi

missions. Asset dedication offers the possibility of a “set it and forget
it” portfolio that generates predictable income over a chosen time
horizon with no active management required. Hopefully, this will
encourage a new, low-cost form of financial management, following
the footsteps and philosophy of discount brokers and index funds.
In addition, asset dedication provides the best opportunity for
long-term growth, nullifying the turbulence and risks of short-term
market movements. With a single stroke, individual investors who
prefer the do-it-yourself route can set up a portfolio that will run for
up to 10 years (or even more in special cases) with no further need for

active management unless that is desired. To top it off, this strategy
outperforms all portfolios that have up to 70 percent invested in
stocks, based on the historical record going back to 1926.
The chapters in this book were designed to be read in
sequence, as each one builds on the others. The chapters in Part 1
describe asset allocation and its flaws and demonstrate how asset
dedication contrasts with asset allocation. The final chapter (Chapter 4) presents the heart of the evidence in favor of asset dedication,
using comparisons over four historical time spans—back to 1990,
1976, 1947, and finally 1926.
Part 2 introduces the idea of the critical path and shows how
younger investors who followed it could have avoided the kinds of
problems that many investors faced when the market declined in
2000. Tracing the financial projections of a couple from age 56 to
age 102, these chapters demonstrate how personal investors can
use asset dedication both before and after retirement. It includes
step-by-step instructions on how to use the web site that accompanies this book. Finally, Chapter 9 ends Part 2 by describing how
asset dedication can be used for lumpy withdrawals, structured settlements in legal cases, charitable foundations, and other situations in which predictability and stability of income are important
without sacrificing the opportunity for growth.
Finally, Part 3 is for those who are newer to the world of
investing or who somewhere along the line missed some of the fundamentals. It examines some of the theory that underlies personal
investing, along with a number of economic, legal, financial, and
portfolio management fundamentals. It also covers the good and
the bad when it comes to forecasting financial markets, describing
some of the problems market timers face and the scams that financial con artists use to take advantage of naïve investors.
Individual investors, institutional investors, professional
advisers, money managers—anyone who needs to generate pre-


Preface

xii

dictable cash flows for him- or herself or others—will benefit from
reading this book. As you come to understand asset dedication, you
will discover the power of building completely customized portfolios
and why asset dedication performs better over the long run. You
will see how to apply asset dedication in real-world situations and
become a better-informed consumer of financial information.
Most books on personal financial management carry the warning that while the authors and publishers believe that the data
from various sources relied upon to reach conclusions were accurate, valid, and reliable, there can be no guarantees in this regard.
The same is true for this book, and its conclusions regarding asset
dedication. No one should consider financial advice from any book
as necessarily the best for their particular situation. Just as each
patient must be examined individually before the appropriate medical steps can be taken, each person’s financial situation must be
considered individually to make certain all the relevant information has been integrated into the recommendations.
A final note: Although the research for this book was done by
both Stephen and Brent, most of the text was written by Stephen.
Whenever a first-person singular pronoun is used (I, my, mine, and
so on), it refers to Stephen.


ACKNOWLEDGMENTS
We would like to thank everyone who helped in the preparation
of this book:
Betty, Steve’s mother-in-law, who provided the original impetus to find a better way to help people find financial security without sacrificing growth. In fact, our initial name for the research
project that led to this book was Grandma’s Portfolio. Patti and
Kim, our wives, who read (and reread) drafts and provided valuable
suggestions based on their own professional training (Patti O’Healy
Huxley is a CFP, and Kimberly Burns is an attorney). They also put
up with husbands who were grumpy from countless late nights and

early mornings. The entire Huxley clan—Ryan (and Kim), Geneve,
Jason, Colleen (and Abilio), Kevin (and Michelle), and Conor (and
Nicole)—for their support. Ryan deserves special thanks for
reviewing first drafts with his incredible engineer’s instinct for
attention to detail, as does his wife, Kim, also an attorney, who
reviewed the book for legal issues at the same time she was carrying their first child, Grace. The Burns boys, Tyler and Kyle, who
seemed to know when their Dad needed some peace and quiet and
who will one day be able to point out their names here to friends.
Robert Burns (no relation), a true friend who developed the web
site that supports the book (www.assetdedication.com) while teaching his own computer programming classes at Diablo Valley College, and who is one of those quiet geniuses who just gets the job
done. Manual Tarrazo and Rich Puntillo, colleagues who teach
finance at USF and reviewed early portions of the manuscript;
in addition to providing valuable comments, they also provided
invaluable encouragement and support. Larry Wiens and Mark
Welch, the first professionals in the financial industry to use asset
dedication for clients. Larry especially provided many insights that
led to improvements. John Dorfman, former analyst for the Wall
Street Journal and a true scholar whose clarity of thought, style of
presentation, and thoroughly professional attitude were not only
helpful but actually inspiring. Ron Judson, Jim Collins, George
Coughlin, and Mike Ricinak, friends who are also finance professionals and who provided insightful guidance and suggestions.
Christine Dispaltro, the dedicated MBA research assistant who
entered reams of data, performed many calculations, and proofread

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xiv

Acknowledgments

pages of material with unerring accuracy and without a whimper.
The staff at McGraw-Hill for their thoroughly professional attitudes
and actions, specifically Alice Manning, who copyedited the manuscript in its entirety with an uncanny ability to spot better ways
to get ideas across and Kelli Christiansen and Pattie Amoroso, who
must be the most responsive and patient editors on the face of
the planet.
Finally, our thanks to our many friends, acquaintances, and
familiy members who endured our ups and downs (specifically Ann,
Rawley, Hank, Steve, Shirley, Jan, Ofelia, Andrew, Jack, Barbara,
Russ, Vicki, Pat, and Fred). They may not realize how much their
words of support and encouragement helped our resolve to bring
the book to completion.
Any errors are entirely the responsibility of the authors.


ASSET
DEDICATION


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PART

1

Asset Dedication—
The Next Step
in Asset Allocation

Every single dollar in a portfolio should be where it
is for a specific reason. If it has no reason, it should
not be there. It should be somewhere else.

New ideas often take a long time to replace old ideas. Max
Planck and Albert Einstein, two of the greatest minds that ever
blessed the human race, faced similar resistance when they
put forth their new theories about how atomic particles behave
and how the universe works. Most of the scientific community
was suffering from intellectual inertia and scoffed at their
ideas. Acceptance often takes several decades to achieve. J. H.
Northrop, 1946 Nobel Laureate in Chemistry, in attempting to
explain why it takes so long, quoted Max Planck as saying,
“Scientists never change their minds, but eventually die.”1
This book presents a new idea for personal investing that
challenges the dominant paradigm, asset allocation. Whether
it will face the same sort of resistance as Planck’s quantum
mechanics or Einstein’s relativity theories remains to be

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2

Asset Dedication

seen. The financial industry moves quickly if it sees something that looks like it might be in its best economic interests.
However, much of the industry is dependent upon the asset
allocation paradigm, and changing its tune may be a slow and
arduous process. Asset allocation means different things to

different people, and the way it is practiced today is often
only remotely related to the way it was originally envisioned.
Many financial planners have taken the extensive training needed to acquire the title of Certified Financial Planner,
the premier credential in the industry. But many stockbrokers
who work for large mainstream brokerage houses like Morgan Stanley or Merrill Lynch are little more than salespeople,
paid to attract customers. Their primary focus is on selling
services that make money for themselves and their company.
It is not on looking out for the best interests of the people who
invest with them. Recent scandals reported in the media suggest that such behavior is rampant in many parts of the
financial community. The former chair of the Securities and
Exchange Commission is quite blunt about it: “Investors
today are being fed lies and distortions, are being exploited
and neglected.”2
The purpose of this book is to introduce a new idea: asset
dedication. To some financial theorists, asset dedication is
simply the natural next step in the evolution of asset allocation. To others, it appears to be the first step in “post-modern
portfolio theory,” an entirely new way to handle the common
issues faced by individual investors. The vast majority of people are not financial theorists, of course, and are not particularly interested in how asset dedication is perceived to fit into
financial theory. They simply want a financial strategy that
they can understand and that works. This book will provide
the evidence, based on the actual historical record of the stock
and bond markets since 1926, that asset dedication is both.
If you start more books than you finish, Part 1 is for you.
It summarizes the fundamentals of asset dedication and
explains why it appears to be superior to asset allocation. If
you already know something about investing, Part 1 may be
enough to give you a sufficient understanding of this new
investment strategy, and Part 2 will provide more specific

Asset Dedication

3

details. If you are relatively new to investing, then Parts 1
and 2 will get you started, and you can arm yourself with Part
3, which describes the theories and conventional wisdom that
underlie financial markets and the economics of investment.
Before we get started, it needs to be pointed out that personal financial planning has many different elements. This
book does not cover them all. For example, it does not cover
estate, trust, or tax planning. You can be the best stock or
bond picker in the country, but when the IRS gets through
with you, it won’t matter. Consultants and attorneys who specialize in the highly technical details of these matters need to
be involved. Different states have different legal provisions,
the laws governing such matters change periodically, and
every person’s situation must be examined individually. Getting the job done professionally may cost several thousand
dollars, but this is cheap compared to the additional taxes,
probate fees, internal family conflicts, and so on that are
likely to ensue without it.
On the other hand, knowing the legal regulations concerning trusts, wills, charitable giving, IRA accounts, and
other such things does not make an attorney or even a financial adviser a superior investment policy strategist. In fact,
psychologists have a name for the fallacy of believing that
just because a person is good at one thing, that person will
also be good at something else. They call it the halo effect, and
it tends to color our perceptions of the people who give us
advice. This book assumes that the legal and tax issues associated with different types of accounts have already been settled. What is needed next is a way to preserve and enhance
the performance of the funds in those accounts. That is where
asset dedication comes in.
Do not think that this book will lead to quick riches.
Books that promise that are usually designed to attract readers who are devoid of discernment. This book describes a

strategy that offers a simple way to take advantage of the
best things the market has to offer to most individual
investors, either by themselves or with the help of ethical,
competent advisers. It is a strategy that works. The evidence
is here. You be the judge.


4

Asset Dedication

NOTES
1. J. H. Northrop, Nobel Laureate, Chemistry, 1946, “There is a complicated hypothesis
which usually entails an element of mystery and several unnecessary assumptions.
This is opposed by a more simple explanation which contains no unnecessary assumptions. The complicated one is always the popular one at first, but the simpler one, as a
rule, eventually is found to be correct. This process frequently requires 10 to 20 years.
The reason for this long time lag was explained by Max Planck. He remarked that
‘Scientists never change their minds, but eventually die.’” Reported by Dr. Robert
Baffi in “Design vs. Darwin: A Scientific Controversy,” The Light Bulb, Volume II,
Issue 1, Summer, 2003 (www.ideacenter.org). The Max Planck statement to which
Northrop was referring is as follows: “. . . a new scientific truth does not triumph by
convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.” From
Scientific Autobiography and Other Papers by Max Planck (Nobel Laureate, Physics,
1918), translated by F. Gaynor (New York, 1949), pp. 33–34, as reported in The Structure of Scientific Revolutions by Thomas S. Kuhn, 2nd Ed. (Chicago: The University of
Chicago Press, 1970), p. 151.
2. Quoted from the jacket cover of Arthur Levitt, Take on the Street (New York Pantheon,
2002). Levitt was chair of the Securities and Exchange Commission (SEC) from 1993
to 2000.

CHAPTER

1

Asset Allocation—
the Dominant
but Procrustean Paradigm
In Greek mythology, Procrustes was a thief along the road
to Athens who offered travelers a magical bed that would
fit anyone. He then either stretched his guests or cut off
their legs to make them fit the bed.

A

sset allocation became the dominant paradigm of investment
strategy in the late 1980s. A research paper in a respected academic
journal suggested that over 90 percent of the variation in a portfolio’s return could be explained by the way the funds were allocated
among the three major asset classes: X percent to stocks, Y percent
to bonds, and Z percent to cash.1 This was widely misinterpreted to
mean that if you follow an asset allocation strategy, you will capture 90 percent of whatever returns are available. In fact, the misinterpretation spread so quickly and widely that later researchers
referred to it as the “universal misunderstanding.”2
Academic researchers understood the true meaning of the 90
percent, and a number of them tried to set the record straight.3 But
it was too late. The mainstream brokerage community had already
headed down the asset allocation path, and asset allocation

5
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6

Asset Dedication

remains the preeminent model used throughout the investment
industry today. In a nutshell, financial advisers classify investors
in broad categories (such as “conservative,” “moderate,” or “aggressive,”) and allocate percentages of their assets to the basic asset
classes following simple, prefabricated formulas. When clients
come into an office, they fill out a questionnaire that is supposed to
place them in the right category. An “XYZ” formula for that category is then recommended and, bingo, on to the next client.
Investors are also told to rebalance their portfolio allocations at
least annually, using the original formula or some other formula that
the company claims is better this year (better for whom—itself or its
clients—is sometimes open to question). It is very much a cut and
dried, wholesale approach to investment advising. Large brokerage
firms were attracted to the idea of asset allocation because it allowed
them to control the advice their employees were giving to prospective
clients. It ultimately evolved into a very procrustean paradigm.
A new challenger has appeared, however, that may unseat the
champ: asset dedication. Based on computer and Internet technology
that was not widely available until the 1990s, asset dedication looks
at the personal investor’s problem from a different angle. The name
and principles of asset dedication grew out of the same concept of
dedicated portfolios that institutions have been using for years to
match the flow of cash coming in with the flow of cash going out.4
Asset dedication applies the same idea to each investor’s individual situation. It dedicates specific assets to his or her specific
goals. By customizing the dedication of assets for each individual, it
provides an inherently better fit than the “off-the-rack” approach.
Research also demonstrates that it delivers superior returns while
simultaneously insulating investors from short-term market

declines (see Chapter 4). It may well become the first major shift in
investment strategy since the advent of asset allocation.
With asset dedication, allocations are no longer based on fixed,
arbitrary formulas, so there is no longer a need to rebalance the
portfolio to maintain arbitrary XYZ proportions. The allocation proportions actually change over time in a dynamic fashion that
depends on the length of the planning horizon and the target goals.
Some people may see asset dedication as a strategic shift in portfolio management theory. Others may see it as a tactical shift in how
portfolios are engineered. Still others may see it as filling gaps in
asset allocation and simply the next step in its evolution.
Regardless of its perceived niche in the theory of personal
finance, the real issues are how asset dedication attacks the problems faced by investors who are seeking to take care of themselves


Asset Allocation—the Dominant but Procrustean Paradigm

7

financially and how it differs from asset allocation. To comprehend
the differences, however, the approaches of both strategies must be
understood. We will start with asset allocation.

THE ROOTS OF ASSET ALLOCATION
Why the Brokers Loved It
We begin with the way asset allocation was originally intended.
The theory is easily understood, which probably explains its wide
acceptance within the financial community in spite of the questions
raised against it (one critic even called it a hoax).5 Most advisers
embrace asset allocation wholeheartedly because they do not have
enough technical training to understand the criticism. In fact, if
you start a serious conversation with someone in the financial

industry, you will generally hear the words “asset allocation”
within a minute or two. (If the person you are talking to seems to
think that this is the first time you have ever heard the phrase, my
advice is to terminate the conversation as politely but as quickly as
you can. You are being set up for a sales pitch.)
The current popularity of asset allocation began with a 1986
paper by Brinson, Hood, and Beebower (BHB).6 They examined the
performance of 91 pension fund managers over the 10-year period
from 1974 to 1983. The managers were seasoned professionals who
were supposed to know how to actively manage portfolios for maximum performance. They were supposed to know which stocks and
bonds to select and how to time the market (when to buy low and
when to sell high). They earned their living by convincing clients
that they were worth their fees because they consistently beat the
market as a result of their tinkering. Conventional wisdom at the
time agreed with them. Index funds were not yet widely researched.
BHB challenged the conventional wisdom. The researchers
compiled what is known as an attribution study to see how much of
each portfolio’s performance could be attributed to active management (timing and selection) and how much could be attributed to
the simple percentage allocations to stocks, bonds, and cash over
the 10-year period.7
The results were bad news for the professional pension managers. The study suggested that their stock selection and timing decisions had actually hurt rather than helped the overall performance of
their portfolios. If they had simply invested their portfolios in index
funds for stocks and bonds (and U.S. Treasury bills for cash) and had
not changed their underlying average allocation percentages, their


8

Asset Dedication

portfolios would have returned an average of 10.1 percent per year.
But their active involvement in trying to pick winners and time the
market actually reduced the return to only 9.0 percent. In other
words, their active management lost an average of 1.1 percent per
year! The numbers would have been even worse if the fees the managers charged had been included. The difference between 9.0 and
10.1 percent per year may seem small, but because of the power of
compounding, the difference over time can become significant. For
example, assume that Mr. and Ms. Brown (whom we will meet later)
were 10 years from retirement and had already accumulated a nest
egg of $275,000 in their 401(k) retirement fund. At 10.1 percent, this
would grow to $719,790 by the time they retired, but at 9.0 percent,
it would grow only to $651,025, a deficit of $68,765. If this difference
does not seem like a significant amount of money to you, you are
probably in a different league from most people who read (or wrote)
this book.8
BHB concluded that what mattered most was the managers’
basic allocation decisions. When BHB correlated actual quarterly
returns with the returns that would be generated from passively
investing in generic index funds, they found that, on average, 94
percent of the variation in quarterly returns could be explained by
the allocations alone. The impact of the managers’ selection and
timing decisions was trivial by comparison, contributing only the
remaining 6 percent.9 Later work by the same authors with data
covering 1977 to 1987 and additional research by other academics
reached the same conclusion.10
The fact that portfolio returns were strongly correlated with
stock returns is not too surprising from a statistical standpoint.
Stocks are much more volatile than either bonds or cash. That
means that stocks are the component that introduces most of the
variability into any portfolio, whether they represent a large or a

small portion of the overall value. It therefore makes intuitive
sense that movements in the quarterly returns of any portfolio will
closely follow the quarterly returns of a stock index, unless the particular stocks selected are totally out of synch with the market.
Nevertheless, BHB startled the investment community. Most
people had thought that actively managed portfolios were superior.
But now it appeared that active management of portfolios was a
waste of money. The research was interpreted to mean that it was
much better to follow an asset allocation formula and leave the
portfolio alone than to tinker with it. Theoretically, there was no
need for active professional managers once the allocation decision