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The Case for Goals-Based Investing Thumbnail

The Case for Goals-Based Investing

By: Shrey Patel

Chief Portfolio Manager, The Milwaukee Company 

One of the most important aspects of being a successful investor is developing a portfolio management process that encourages disciplined behavior.  Ideally, the process should cover everything from asset allocation to security selection, while minimizing surprises and short-term noise.  The goal is to utilize a portfolio management process that instills the confidence needed to stick with the investment strategy when the markets turn against it (as it inevitably will happen).

As intuitive as it may sound, accomplishing such a framework is challenging.  At the outset, the process requires identifying an appropriate investment objective and risk tolerance for an investor.  Traditional methods such as risk tolerance questionnaires are a good start, but can be undermined by the natural tendency for the quiz-taker to over-estimate his or her true tolerance for risk[1].

For example, assume a risk tolerance questionnaire indicates a balanced investment approach be adopted, while in reality a more conservative portfolio is better suited to the investor’s objectives and personality.  While this may not be a problem when the market is testing new highs, it can become a major issue when market volatility is elevated.  Deeper-than-tolerable drawdowns can trigger panic-induced selling, locking in losses that might have been avoided with the adoption of a more conservative investment objective at the outset.  

Complicating the identification of the proper investment objective, can be a desire for a portfolio to accomplish competing goals with different time horizons, such as education funding, retirement income, providing an inheritance, funding charitable donations, etc.

Goals-based investing (GBI), an alternative to the traditional approach (TA), advocates more granular and investor-centric approaches to developing an investment framework that is well-suited to good times and bad.  GBI involves:

  • Identifying all of the investor’s goals ranging from needs to aspirational.
  • Segregating goals into buckets based on importance and time horizon.
  • Specifying asset allocations for each bucket.
  • Managing each of these buckets as separate sub-portfolios.

According to the CFA Institute, because GBI assigns specific dollars to specific use -- referred to as “mental accounting” -- it does a better job of encouraging disciplined investor behavior.  

The following exhibit illustrates how the GBI framework can be implemented for an investor with five distinct goals and how it differs from TA:

The TA will attempt to meet the target of $6 million at the end of the investment period with a single portfolio with a balanced investment objective.  However, GBI will target the same goal of $6 million but with four different sub-portfolios and four distinct investment objectives: conservative, balanced, growth and aggressive.  The GBI Approach has several advantages:

  • Different goals and their significance are now being taken into consideration.
  • Time horizon and investment objectives for each goal can be clearly identified and planned for.
  • Under-performance within a low-priority sub-portfolio such as the one for vacation home and dream car is unlikely to sabotage the investor’s high-priority retirement goals.  As a result, an investor is more likely to avoid panic selling.

The Milwaukee Company (TMC) has capitalized on the advantages associated with GBI via Core-Satellite portfolio construction.  Like GBI, the client’s total investment portfolio is divided into sub-portfolios, with each sub-portfolio managed using a different investment strategy.  

More specifically, the portfolio’s core is managed using TMC strategies that aim to deliver “market beta” -- that is, returns and volatility consistent with a passively managed, market-weighted portfolio.  The balance of the portfolio is managed using satellite strategies that seek to generate positive “alpha” by generating better than market returns or lower-than-market risk, or both.  However, unlike GBI, the goal of core-satellite portfolio construction is to enhance the risk adjusted returns of an investment portfolio through increased diversification and lower drawdowns.

That said, there is no free lunch, as Mr. Market Commentator would say.  Although GBI offers an elegant and behaviorally sound way to deal with an investor’s several goals, it is no silver bullet.  It works best when there are multiple goals, across different time horizons and varying levels of priority.  And therefore, the profile doesn’t always apply to every investor.  

Notwithstanding the foregoing, GBI can be a great way to deal with the behavioral aspects of investing.   It can help investors and advisors alike to develop portfolios that will encourage adherence to a prudent investing strategy in all types of market conditions.  As history has shown, success on this front tends to equate with substantially higher odds of achieving investment objectives in the long run.

[1] Wall Street Journal, “Your Tolerance for Investment Risk Is Probably Not What You Think”.