Hedge funds and private equity exhibit large dispersion of returns from the best- and worst-performing funds, and the relevant benchmarks use universe comparisons of select funds to calculate results, which may suffer from survivorship bias. Hedge fund benchmarks include data only from funds that are still active, and consequentially suffer from survivorship bias. Underperforming funds may close, and their data is removed from the benchmark. Based on this methodology, the benchmarks may overstate returns and understate risks. There is a great deal of dispersion between the best- and worst-performing private equity fund, especially compared to traditional long-only funds.
The correlations among asset classes is the secret sauce of MPT. Unfortunately, correlations are not static, and they have been increasing over the past couple of decades. This is due in part to the interconnectivity of the various global markets.
In fact, during periods of shocks such as during the global pandemic, correlations rose among most major asset classes. When we need the benefits of correlations most, they fail to retain their diversification benefits. This supports the argument for spreading the risk to more and different asset classes, including alternative investments.
Goals-Based Investing
I began by challenging some of the limitations of MPT: the assumption that investors are rational and will select the optimal portfolio, and that they always seek to maximize returns. Goals-based investing has become a mainstream response to the limitations of MPT, incorporating aspects of behavioral finance to solve for investor needs.
Sometimes referred to outcomes-oriented investing by institutions, this strategy is intuitive and easy to explain to investors, and it fits neatly within the consulting process, providing the flexibility to solve for multiple goals simultaneously. It also moves the discussion with clients from outperforming the market to progress relative to their stated goals, and it reinforces a long-term approach to investing.
Goals-based investing is a natural response to the limitations of MPT. Rather than maximizing returns or minimizing risks, goals-based investing is designed to provide the highest likelihood of achieving a client’s goals over time. While it balances returns and risks, the utility function of goals-based investing is to achieve a desired outcome: capital appreciation, wealth preservation, retirement income, saving for a second home, college funding, or charitable donations.
Because HNW families often have multiple goals across multiple accounts, advisors should determine the specific desired outcomes and establish obtainable goals for each account. Advisors must consistently reinforce progress relative to client goals in rising and falling markets, as well as the predetermined time horizon to achieve those goals. Otherwise, advisors might be tempted to focus on strong performance in good times and revert to the goals when things are tough, losing credibility with clients and making it difficult to keep clients focused on their long-term plans.
This article is an excerpt from Goals-Based Investing: A Visionary Framework for Wealth Management by Tony Davidow, pp. 69-88, (McGraw Hill, December 2021).”
Tony Davidow, CIMA is president and founder of T. Davidow Consulting, LLC an independent advisory firm focused on the needs and challenges facing the financial services industry.