crescet pool

The traditional 'asset allocation' industry typically makes 'investor risk appetite' your problem, not theirs.  They then perform this outdated pre-MPT analysis of the kinds of asset your risk profile might need.  In reality, you need them all, in toto, and your risk appetite only drives the degree of leverage on that total portfolio.  Secondly, using some nineteenth century maths on annuities and perpetuities, they take your requirement of needing a fixed amount at a date in the future, run the formula, and work out what your monthly premium ought to be to achieve that future cashflow.  Note this too works only by eliminating all asset types and strategies except relatively safe loans/bonds, together with a hope that inflation doesn't destroy the real future value.  However, if you're willing to accept uncertainty in the primary return stream (which becomes increasingly OK  the longer your relevant time horizon is), then you can replace a safe (close to risk free) return with increasingly risky returns.

But I think one should try to build a model of the risk appetite, which is to say  a model of the wealth process.  This would be a rather complex process.  Stochastic no doubt, and with feedback from the actual experienced output of your core investment model.  It is much grander (much more destined to failure too) than knocking off a perpetuity to pay for your children's university bill.

Before doing that, it might be worth thinking if there are any macro or qualitative insights which might be gleaned by thinking about a world where everyone, rich and poor, operated a wealth process.  Are there implicit biases in the behaviour of investors based on how wealthy they are?  Secondly, how distributed is wealth?  How does that matter?

Why the long face?

Why the long bias in strategy allocation?  Well, first of all, logically, you need to have a long  market first, and of a sufficient maturity and depth, before you can create institutions enabling shorting activity.  And you need to be able to short in order to perform many hedged and complex strategies.  A set of farmers needed to pre-exist before an institutional framework existed which allowed the possibility of shorting commodity prices.  The primordial investment activity is the handing over of capital for the purchase of goods and/or services that could result in the growth over time of that capital.  The primordial investment activity is the act of sowing seeds, tending to those seeds, managing their growth until a yield is achieved.  The primordial investment activity is in the act of acquiring a herd, having it propagate new members of the herd, while tending to to herd.  At its most basic, you can see that the investment that is being made is often in terms of the time, manual labour and thought, planning and management.  This is the initial investment.  And the outcome is a commodity which is valuable to humanity - wheat, milk, meat.  Here it is clear how work is seen as an investment.  It was originally performed as a machine which transformed effort, planning, time and intelligence (the labour factor, as economist rather plainly summarise it) into goods (commodities).  Insofar as cash is partly an agreed external measure of the value of a basket of goods, then so too can the primordial value be measured.  This is how François Quesnay would have launched the ideas of the tableau économique.

Apart from the logic of chronology, it is a long standing commonplace that investment capital is often used to build or make something.  In modern times, this is especially so, as capital pays for the location, the input materials, the tools and the skill-set and effort of a workforce to manufacture a desired output of production.  In the modern economy, this product usually has a price.  If the primordial investment activity can be thought of as human capital and effort manufacturing the means of immediate physical survival, then this widens to the manufacture of more sophisticated product, requiring more refined division of labour, more expensive tools, a more costly locale.  In short, as the product of economies become more sophisticated than immediate means of survival, those products became more expensive to make, and that made it harder to launch an entrepreneurial episode without having access to capital.  Secondly, there entered into the process an idea of economies of scale, and economies of scale allowed the unit price of goods, all other things being equal, to reduce, which in turn led to more people to be able to afford it.  But scaling an enterprise up in order to reduce unit prices was a costly operation.  Up front capital, in size, was also required.  By these means, the manufacture of goods for broad consumption came to require large sums of capital.

The insurance business was the first great short.  Certain businesses were happy for certain risks to be taken from them.  This act is a kind of hedge, a short.  For farmers, agreeing a pre-harvest price is an example.  For shippers, eliminating the potentially ruinous risk of a loss at sea is a kind of short.  Another early institution of hedging was the conglomerate.  The idea that a business might own divisions which contained businesses perhaps exposed to different parts of the business cycle.  In aggregate, an enterprise might survive better with this build-in diversification benefit.  In a similar vein, having sales distribution agents in different geographies minimised certain risks.  There is evidence of marine insurance in fourteenth century Pisa but primordial economies would also have contained various forms of mutual aid, institutionalised for example in community granaries.  The Greeks and Romans created benevolent societies, proto-guilds, which in effect provided life insurance.  Modern life insurance kicked off after Pascal and Fermat injected genius into the proto-subject of probability theory.  

Futures, and in particular, commodity futures, were the first great single asset of the shorting industry.  Just as life insurance as an industry is an idea based on one's understanding of annuity tables - based on probability theory and correlation of events, so too did the futures market evolve in the eighteen and nineteenth centuries.  If you understood your correlation well, you could make sophisticated estimated of how likely any given kind of person was to die, and how related or correlated that death was to others.  And if you ran your business to sufficient scale, then you could expect to make fairly expert predictions of the expected payout your company might have to make per year due to death.  With this expected cost, and with the knowledge of the size of your insured population of customers, then you could set a premium in a way which protected everyone and made your firm a profit.  With farmers and with properties, these rules were also true, but with agricultural insurance, there was a higher risk of 'correlation one' events - severe weather, for example.  One then needed to have an institution which was either geographically diverse, or which had reserve funds for the occasional severe weather event.  So, with human life and with weather, the institution was using statistics, large numbers, to allow them to arrive at expected yearly costs to run their business.  From this perspective, the futures exchanges were simply insurance hubs with very standardised products.  This allowed the insurers to diversify some of their risks when it suited them.  To do that, it required one further institutional category - the speculative investor.  If an insurance company was providing this kind of service to risk-adverse makers and producers, who was it on the receiving end of the futures contracts which the insurers wanted to use to lay off their risks.

First of all, it has to be remembered that it was (and is) possible to run an insurance business in the absence of a futures market.  The collection of skills which resided in understanding how the correlations worked in death, in accidents, in crop yields, were self sufficient, but that set of skills would spill out into the speculative community.  Imagine you and your work colleagues knew about as much as there was to know about managing the risks associated with running an insurance business.  And imagine you had the idea that you could exploit that knowledge but without having to insure the makers of industrial or agricultural goods.  If you understood the risks, the cycles, the opportunities, perhaps you too might be tempted to start to speculate with the new futures institutions of the nineteenth century. We have the price takers, the makers of the economy, and we had the price makers, the mathematical model builders of the financial and insurance industry, and soon thereafter this set of model builders began to separate into the market makers (who made a profit by offering insurance products to the real economy) and speculators, who felt they could trade those markets themselves to make larger profits.  This division, somewhat related to the 'buy' and 'sell' side of modern finance, somewhat related to the investment banking / hedge fund division of modern banking remains with us today.  Political regimes in the West have sometimes wanted these two sets of model builders to be separated, and at other times, they've conspired to stay close together.  Again, from the point of view of conglomerate-as-diversifier of risk, it is clear why the companies themselves want to stay together and given that there are more risks taken on the speculative side of the business and that model will have low correlation to the insurance business, since they're in aggregate on opposite sides of the trade.

On this reading of history, the futures and options markets play an essential and long running role in the management of risk in developed economies.  Out of these activities has come the concept of superior returns for investors.  The promise that your wealth process can be super-charged, leading to you being financially better off than otherwise.  And with it too has come the possibilities of the various forms of gambler's ruin.  With inflation and transaction costs nipping at the heels of your wealth process, yet with the promise of superior returns to fund your lifestyle needs - the purchase of all those expensive to make products - yet without falling for gambler's ruin, the strategy allocation industry was born, and the long bias in investing is the main reason why the industry sometimes goes by the name of the asset allocation industry.