Asset/Liability Matching and Portfolio Management for Beginners

Couple going over paperwork with financial advisor
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As your net worth begins to blossom and you start to accumulate wealth, you may encounter a concept known as asset/liability matching in the context of managing your portfolio.

Asset/liability matching can be a powerful tool for investors. They use this strategy to convert the capital they've amassed into lump sums of cash and/or passive income from sources like dividends, interest, and rent to meet expected needs.

How Asset/Liability Matching Works

Asset/liability matching attempts to project the specific timing of cash needs, particularly outflows, by an investor. The investor allocates capital so that the portfolio's assets can be sold or liquidated in the future, producing cash when needed. An investor may also allocate portions of their portfolio to income-producing assets like real estate.

Let's look at two scenarios that walk through what an asset/liability matching strategy might look like.

Example 1

Imagine you're a successful entrepreneur. You have a 5-year-old son and a 2-year-old daughter. You want to set aside a portion of your profits to pay for your children's college educations. What you need is a series of lump-sum cash amounts available at specific dates, and at specific times, in the future.

For your son, you need a lump sum available in 14 years to cover his freshman year of college, a lump sum in 15 years to cover his sophomore year of college, and so on. In year 17, you also need the first lump sum for your daughter to cover her freshman year of college. In year 18, your son should have graduated. He may no longer be as reliant on you for financial support, so the only expected outflow should be your daughter's sophomore year of college (although you may want to set aside some funds for your son to be on the safe side). In years 19 and 20, you'll primarily fund your daughter's college education.

An asset/liability matching program would build a portfolio that could handle this liquidity timing. For example, a fair analysis of historical stock market behavior tells you that any individual stock, or group of stocks, can easily decline in market value over a very short time even if the underlying business is thriving.

Given this fact, a good rule of thumb is to avoid having any funds you'll need within the next five years invested in common or preferred stock unless you believe the dividend income alone will be sufficient to meet your liquidity needs.

Example 2

Imagine you're a professional who amasses real estate on the side. You negotiated the purchase of a $2 million office building in the Midwest with the former owner, who allowed you to buy the property by coming up with a $400,000 down payment then making regular monthly payments on the remaining $1.6 million as if it were an amortizing mortgage over thirty years. However, after seven years, the entire remaining balance is due in full.

You would prefer to pay off the building entirely at the seven-year mark. You plan to take any surplus cash flow from the property, combine it with your other income sources, and build it up so that it's there on the maturity date and you can pay the debt in full without needing to refinance the loan. An asset/liability matching approach would involve selecting investments that offered the best opportunity to have the funds when you need them, which might mean selecting lower-risk investments to preserve your savings.

The Benefits of Asset/Liability Matching

The biggest advantage of using an asset/liability matching approach in portfolio management is that it allows you to significantly reduce many of the risks you might face as an investor if the program is designed and implemented wisely. Here are some examples.

It Reduces Reinvestment Risk

Reinvestment risk refers to the risk that you won't be able to reinvest the cash flow from an investment at the same or higher rate of return as the initial investment, resulting in a lower overall compounding rate than you projected. With an asset/liability matching approach, you might choose something like a zero-coupon bond rather than a traditional bond. A zero-coupon bond is bought at a discount, and you redeem it at face value at maturity. A zero-coupon bond has a higher sensitivity to interest rates, but that ultimately doesn't matter given that you hold it until maturity.

It Reduces Liquidity Risk

By introducing a hard deadline on when funds must be available, an asset/liability matching strategy tends to emphasize the safety of principal, or capital preservation, more than an open-ended investment mandate might. This can help the investor or portfolio manager better determine which types of securities, maturities, and other features of a given security or asset class are most appropriate. Of course, this isn't always foolproof. For example, many investors found themselves holding auction-rate securities during the Great Recession collapse of 2007-2009. Some lost millions of dollars in what they erroneously believed to be a highly liquid cash equivalent.

It Helps Defend Against Action Bias

Once you have developed and implemented a plan that involves asset/liability matching, it's easier to emotionally handle market volatility because your eyes are fixed on the end date. This can mean avoiding mistakes when the economic storm clouds gather, which is an extremely important factor that many investors discount.

While you can attempt asset/liability matching on your own, it's best to work with a financial advisor or planner experienced in this strategy.

When to Use Asset/Liability Matching

Here are a few situations where you might consider developing and implementing an asset/liability matching strategy.

  • Planning for retirement.
  • Funding a college education for your children, grandchildren, nieces, nephews, or other heirs or beneficiaries.
  • Planning for the purchase of a home, second home, or investment property.
  • Planning for the maturity of a mortgage or other debt with a balloon payment component in the promissory note.
  • Making regular tax-free gifts up to the gift tax limits as part of a multi-year or multi-decade estate tax mitigation strategy intended to lower the value of your estate.
  • Funding potential payouts for lawsuits or other liability exposures that might take years to resolve.
  • Setting aside funds to pay for a child's wedding.
  • Creating a pool of capital that will eventually fund the start-up of a business or an expected investment.
  • Setting up a reserve of capital that will be used to cash out a partner in a limited partnership, a member in a limited liability company, or a stockholder in a corporation.
  • Setting aside money to be used to pay an expected tax bill.