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 Unfortunately, using flawed or outdated data may mean that investors fall short of both their return and income requirements.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.

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