Why goals-based investing makes sense
Financial advisors and investment managers use 21st-century tools to help clients achieve “real” investment success.
Financial advisors who use fee-based managed accounts can more effectively help clients meet their investment objectives if they incorporate goals-based strategies—as well as behavioral finance techniques—to minimize the irrational client behaviors that can derail an investment plan.
Goals-based investing has two meanings in today’s retirement planning environment:
- The practical notion that an investment plan should be based on achieving realistic goals customized to an individual’s (or couple’s) overall financial-planning requirements, risk profile, and time horizon—not some far less relevant market benchmark.
- The philosophical idea that investment success should be measured on how it helps clients achieve the lifestyle goals they desire. Those goals could be basic, such as attaining a comfortable retirement income stream. Or, they could also be more ambitious, such as helping fund a grandchild’s college education, buying that second home in the Caribbean, making a significant contribution to a favored charity, or going back to school to jump-start a new career.
These two descriptions of goals-based strategies are intertwined and present unique challenges and opportunities for advisors in today’s financial environment.
The article goes on to describe how these needs might be broken into three buckets when a financial and investment plan is constructed:
- Essential needs: food, clothing, shelter, everyday expenses.
- Lifestyle “wants”: vacations, a new car, luxury items.
- Legacy “aspirations”: family, endowments, charity.
For decades, investment and financial advisors have applied the principles of modern portfolio theory (MPT), the capital asset pricing model (CAPM), and the efficient frontier theory when constructing client portfolios. These principles were largely based on the work of American economist Harry Markowitz, who wrote an article titled “Portfolio Selection” in 1952, published in the Journal of Finance. That paper laid out the mathematical arguments in favor of portfolio diversification. Markowitz later shared the Nobel Prize in Economics in 1990 with two other scholars “for their pioneering work in the theory of financial economics.”
MPT theory retains strong advocates, and it generally served investors well during the last few decades of the 20th century. Says Investopedia, “Modern portfolio theory has had a marked impact on how investors perceive risk, return, and portfolio management. The theory demonstrates that portfolio diversification can reduce investment risk.”
There is little doubt that focusing on the relationship of risk and return was, and is, a compelling and positive tool for investors and their advisors as they consider investment options. Efficient frontier theory took this to a new conceptual level, identifying “the portfolio composition(s) that provide one with the maximum return for a given degree of risk or, alternatively, the least amount of risk for a given return” (efficientfrontier.com).
On a theoretical level, this sounds vastly superior to selecting investment vehicles and portfolio composition with little regard to risk. And it is. MPT and efficient frontier theory still have valuable roles to play in examining portfolio alternatives.
Note: This graph is an example of what the efficient frontier equation looks like when plotted. The purpose of the efficient frontier is to maximize returns while minimizing volatility.
But the broad and deep market downturns of the 21st century exposed some serious weaknesses in the theory of classic asset-allocation strategies and MPT, especially as they relied on a passive approach to investing. Advisors and their clients witnessed several “real-world” effects on markets and investor behavior in times of severe stress, such as that seen during the dot-com meltdown and the more recent credit crisis:
- MPT/efficient frontier theory was severely challenged by traditional asset-class correlations not behaving as expected, which was explored in Proactive Advisor Magazine’s article, “A more efficient (and profitable) frontier.” That article examined one of the key underpinnings of efficient frontier theory, concluding,
- The “sequence-of-returns” dilemma undermines even very capable application of MPT for client accounts. As numerous studies have shown, when clients are in the distribution phase of retirement, the sequencing of their investment returns can have disastrous effects on the long-term viability of generating an income stream. Put simply, two portfolios may have the exact same “average return” over a 20- or 30-year period, but the timing of those returns can mean the difference between building a very comfortable retirement trajectory and simply running out of money.
- Classic passive asset allocation according to MPT, while perhaps “maximizing” return relative to risk, does not mean risk is totally mitigated. As one experienced financial advisor told Proactive Advisor Magazine, “I was a firm believer in modern portfolio theory up until the financial crisis of 2008–09. I always thought it was sufficient to have client portfolios that were optimized as much as possible for risk and return. However, while a portfolio might beat the worst of the market’s performance in a severe crash, it is still unacceptable to see portfolio declines of over 20% or 30%.”
- To the point above, the most troubling aspects of client behavior can surface when markets crash—despite having “well-constructed” portfolios. The herding mentality can come to the forefront when investors perceive “the investment world is coming to an end,” and emotional panic dominates decision-making. In their 2015 book “Applied Asset and Risk Management,” authors Marcus Schulmerich, Yves-Michel Leporcher, and Ching-Hwa Eu had this to say in their chapter “Modern Portfolio Theory and Its Problems”:
It is perhaps easiest to start with what goals-based investing is not. It is not an investment plan that seeks to duplicate broad market results or build comparisons to popular market benchmarks.
It starts with a financial plan that attempts to identify realistic levels of returns that will help a client meet their financial goals, typically beginning with the most fundamental goal of generating adequate income (along with other sources) in retirement.
By its very nature, a goals-based investment plan will not see returns anywhere near those of the best bull markets. But, importantly, it should also not suffer the worst drawdowns seen in severe bear markets. In general, the objectives of a goals-based investment plan are to smooth out volatility, achieve steadier returns, and project a range of returns for a client that is consistent with their risk profile and has a reasonably strong mathematical probability for success over time.
In very simple terms, if a client requires returns from an investment plan (with all other factors being considered) that average 4% over time, a goals-based investment plan might target an expected annual range of 2%–8%. Will there be outlier years to both the upside and downside? Of course. But the goal is to minimize their frequency and their severity, and manage risk such that portfolio drawdowns are consistent with an investor’s risk tolerance.
It is perhaps most instructive to summarize how a few leading investment-management firms broadly describe a goals-based investment approach.
In an article for Advisor Perspectives in November 2015, Matthew Rubin of Neuberger Berman said,
By incorporating goals-based strategies, the investment managers listed above and many others work with advisors to better tailor investment approaches to meet clients’ specific needs and desires. Combined with the behavioral finance benefits of this process, clients are more likely to have realistic and achievable expectations, enabling them to stay the course to meet—or even exceed—their stated goals.
CNBC recently quoted Ashvin Chhabra, former chief investment officer at Merrill Lynch Wealth Management and author of the book, “The Aspirational Investor: Taming the Markets to Achieve Your Life’s Goals.” Said Mr. Chhabra, “At the end of your life, saying ‘I beat the S&P by 3 percent’ doesn’t mean anything. But if you say, ‘I invested well, I had a nice house, my kids went to a good school,’ that’s something.”
Katie Kuehner-Hebert is an award-winning journalist with more than three decades of experience writing about the financial-services industry. She has expertise in banking, insurance, financial planning, economic development, and employee benefits and her work has appeared in many leading publications.
David Wismer is editor of Proactive Advisor Magazine. Mr. Wismer has deep experience in the communications field and content/editorial development. He has worked across many financial-services categories, including asset management, banking, insurance, financial media, exchange-traded products, and wealth management.