This article is an excerpt from Goals-Based Investing: A Visionary Framework for Wealth Management by Tony Davidow, pp. 169-188, (McGraw Hill, December 2021).
Goals-based investing addresses some of the limitations of modern portfolio theory (MPT) and blends attributes of behavioral finance, to solve for investors’ needs, wants, and desires. In this article, I frame the merits of goals-based investing, discuss how wealth advisors can incorporate it into their process, and provide a case study to bring the concept to life.
MPT has helped advisors and investors understand the advantages of diversification by minimizing risk, with the correlation across asset classes serving as the “secret sauce.” However, MPT is built on several flawed assumptions, including the notion that investors are rational and will select the optimal portfolio. MPT also relies upon historical return, risk, and correlation data to design the optimal combination of asset classes to either maximize returns for a given level of risk or minimize the risk for a desired level of return.
But what if equity returns and bond yields are lower in the future? What if the correlations across asset classes remain elevated? Unfortunately, using flawed or outdated data may mean that investors fall short of both their return and income requirements. This is precisely the environment we find ourselves in, with capital market assumptions projecting substantially lower returns and income over the next 10 to 20 years. Correlation data has been steadily rising due to the interconnectivity of the global markets.
MPT is mathematically driven, with the inputs determining the outputs. Behavioral finance is emotional, focusing on how investors respond to stimuli. Mean-variance optimization is designed to maximize returns for a given level of risk or minimize the risk for a given return target and has certain built-in limitations, including the viability of the inputs.
Goals-based investing recognizes that investors are often solving for multiple goals simultaneously and maximizing returns may not be one of those goals. This investing strategy moves the wealth advisor’s discussion from outperforming the market to achieving client goals while aligning the portfolio allocation to those specific goals.
Goals-based investing is designed to increase the likelihood of achieving life goals: accumulating wealth, generating income in retirement, saving for college, giving to charities, or some other specific outcome. Affluent families pass on wealth from generation to generation through trusts, and they often fund numerous charitable activities. They may have multiple account types with different goals and objectives for each. Goals-based investing also provides the flexibility of solving for multiple goals across multiple portfolios.
Goals-Based Wealth Management
Goals-based wealth management marries financial planning and investment planning, providing a road map for investors in achieving their goals. It begins with the discovery process, trying to understand the HNW family’s objectives. Where the traditional approach is to solve for multiple family needs in one portfolio, goals-based investing provides a framework for solving multiple goals, with different cash-flow needs and time horizons, with multiple portfolios. The goals-based wealth management process considers the various family goals.
Discovery Process: What are the family’s needs and wants? What are the various account types? What is unique about each account type?
Reviewing trust and estate issues: What types of trusts have been established (living, revocable, irrevocable, generation skipping, etc.)? How are assets distributed? Who receives them (children, grandchildren, charity, etc.)?
Establishing goals and objectives: What are you solving for (per account type)? What are the cash-flow needs and various time horizons?
Developing asset allocations: What are the return objectives for each account type, the income requirements, the time horizon to achieve the various goals, and the liquidity requirements?
Selecting the right investments: Which fund or manager can generate the required outcome? What are the structural trade-offs among mutual fund, ETF, separately managed account, registered fund, or private fund? How should you incorporate active and passive strategies? What role do alternative investments play in this diversified portfolio?
Monitoring progress relative to goals: How are the managers and accounts doing relative to their stated goals? Have there been changes to the family’s circumstances? Do you need to make portfolio adjustments?
Advisors who adopt a goals-based wealth management process must be consistent in measuring progress relative to goals. They cannot fall into the trap of emphasizing performance in rising markets and goals-based investing in challenging environments. Their performance measurement tools need to evolve to report progress appropriately, rather than emphasizing performance relative to the S&P 500 or some other arbitrary benchmark.
The Means To The Ends
A client’s portfolio is the means to an end. It’s how their wealth grows over time and how they achieve their desired outcomes. Adopting a goals-based approach does not mean that wealth advisors should ignore performance, but rather change the utility function to solve for a family’s objectives. HNW families obviously want and expect access to the best investment strategies. However, if the top-performing strategies come with high volatility and high turnover, then their value may be negated on an after-tax basis.
If assembled correctly, portfolios can solve for specific goals, and if you properly understand the role of each investment, you can measure its effectiveness in the overall portfolio. As covered throughout my book Goals-Based Investing, I tend to think of asset classes as puzzle pieces. If they fit together well, they provide a clear picture of what the portfolio is designed to do. If they are put together in a haphazard fashion, the portfolio’s purpose will not be clear. (See figure 1.)
To help clients understand the role of various investments in their portfolio, I like to use puzzle pieces to illustrate the individual role of each investment, and how they need to come together. This puzzle piece analogy works well with clients because it helps demystify the individual investments and establish their role in a diversified portfolio. It is more intuitive for clients if we frame the investments in terms that they understand, such as growth, income, defense, and inflation hedging.
This framework establishes a more effective way of measuring each investment’s success and failure. Commodities like gold are not in a portfolio to outperform the S&P 500. They are a defensive asset, included in a portfolio to provide safety and stability in the face of market shocks and help hedge the impact of inflation. Fixed income, as the name suggests, is designed to generate income in portfolios, and equity-oriented strategies are focused on generating growth.
This framework also makes it easier to include complex investments like alternative investments. Alternatives are valuable and versatile tools, but they can be confusing for investors to understand. Using this framework simplifies the discussion considerably by putting the investment into terms investors understand.
By framing the asset class discussion like this, advisors can move investors from benchmarking everything to the S&P 500 in rising markets and to cash in falling markets. HNW families may own many of the same asset classes across account types but may weight the accounts differently to achieve the various goals. A trust established for grandchildren may be more growth-oriented because of their long time horizon. The patriarch’s retirement account may be geared toward generating income, and the personal account may be more defensive, based on their views of the prevailing market environment.
Family Goals
Wealthy families are typically solving for multiple goals simultaneously and are not focused solely on maximizing returns. Their objectives may include preserving wealth, transferring wealth efficiently, and funding causes that matter to the family. A family’s wealth may determine priorities, and it may be instructive to review the hierarchy of financial needs.
Cash-flow needs. Meeting the basic needs for food and shelter.
Financial safety. The ability to create a financial cushion for unforeseen events.
Accumulating wealth. Building wealth, saving for retirement, and paying down debt.
Financial freedom. Adequate savings for retirement, children’s educations, and vacations.
Legacy. Focused on estate planning, tax planning, charitable giving, and instilling value in children and grandchildren.
A family may be solving for various needs simultaneously. A family’s personal account may be focused on accumulating wealth, their retirement accounts focused on financial freedom, and their trusts established for legacy purposes.
Case Study:
Tom and Patricia Morgan have two children, Charlie and Samantha. Tom and Patricia have recently retired, they have $5 million in savings and no debt. Charlie and his wife Lisa have two children ages 13 and 15 years old. Charlie is an architect and Lisa is a nurse. They have $1 million in savings and are focused on saving for the children’s college expenses and traveling with the family. Samantha is a single mother, with $500,000 in savings, and a young daughter with special needs. Tom and Patricia have set up trusts for the children and grandchildren to help them achieve their respective goals. (See figure 2.)
An advisor might treat this family as a single relationship, but their respective goals and objectives will be very different depending upon the respective dollar amounts, cash-flow needs and time horizons. A family shouldn’t be defined by their wealth. Each account should have its own goals and a customized portfolio designed to meet those goals.
Incorporating Goals-Based Investing
Working with HNW families requires a broader set of capabilities, moving beyond the portfolio. Wealth advisors need to evolve their practices to better meet the growing needs of these investors, evolving from selling products to solving needs, and expanding capabilities to include trust and estate issues, dealing with concentrated positions, lending, charitable giving, and tax management. Goals-based wealth management provides the framework for addressing these needs.
Wealth advisors should adopt a goals-based wealth management approach to solve the needs of HNW families, changing their relationship and value proposition to better align with the family’s goals. HNW families have complex needs, and goals-based wealth management is designed to identify them and then deal with them individually. Goals-based wealth management is the preferable model for both wealth advisors and HNW families.
Goals-based investing provides a road map for families large and small. Some families may be more focused on intergenerational wealth transfers, and others may be more focused on retirement planning. Some may be focused on charitable giving, while others are solving for college funding. Typically, HNW families are solving for multiple needs simultaneously, and their portfolios should be tailored to meeting each goal.
Wealth management is an ever-evolving set of disciplines. The one constant is serving the needs of families. Larger families often have more complexity and may require specialized team coverage. Wealth management is a multigenerational endeavor; therefore, it is incumbent on the advisor to develop relationships with the whole family to effectively deal with the inevitable wealth transfer challenges to come.
Key Takeaways
Goals-based investing is designed to identify and solve for multiple goals simultaneously. Rather than merely optimizing a portfolio to maximize returns or minimize risks, goals-based investing recognizes that HNW families have multiple goals, with different cash-flow needs, and different time horizons to achieve them.
A goals-based wealth management process provides the framework for achieving various goals across family accounts and developing the appropriate solutions for each account. Family goals are typically geared toward life events like transferring wealth, college funding, and charitable giving, each of which requires a dedicated focus to achieve the desired outcome. Affluent families are increasingly considering sustainable investing, aligning their portfolios and purpose, and wealth advisors need to understand and respond to this growing trend.
Wealth advisors need to engage all HNW family members and develop relationships with children, siblings, and other trusted advisors. A few tactics to engage wealthy families include engaging the children, educating the family, conducting family meetings, developing personal relationships and developing a family mission statement.
In this article, I examined the limitations of traditional finance, including MPT, and discussed behavioral finance and the inherent biases that we all exhibit. MPT assumes that investors are rational and will select optimal portfolios; it assumes that the future will be like the past. Not all investors seek to maximize returns or minimize risk. Most investors are solving for multiple goals with different time frames to achieve those goals. Goals-based investing is a more appropriate way of solving for client needs, marrying attributes of MPT and behavioral finance.
In this article, I suggested framing the investment discussion in terms of the role that the various investments play—growth, income, defense, and inflation hedging. A HNW family may use similar investments across their various accounts, but the weighting of the investments will vary based on their respective goals, cash flow needs, risk-tolerance, and time horizon, among other issues.
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.