Academic research incorporating behavioral portfolio theory (BPT) and modern portfolio theory (MPT) shows that goals-based investing is fundamentally different from risk-based investing while still being consistent with MPT. Recent award-winning research1 by Franklin Templeton and Sanjiv Das and Daniel Ostrov of Santa Clara University incorporating these concepts prove that goals-based portfolios should change their risk levels as the time to the goal changes and with the impact of portfolio performance. This patent-pending approach is not just an academic exercise. The adaptive approach can significantly improve investor outcomes. Furthermore, our studies show how applying these findings, along with machine learning, can lead to highly personalized portfolio paths for the unique goals of investors.
As goals-based planning and investing come together, static, non-personalized portfolio management is ripe for disruption which in turn will lead to significant improvement in investor outcomes. However, the delivery of these improved outcomes requires a shift in the entire value chain of wealth management, technology infrastructure and asset management solutions.
Our paper details our findings and suggests key changes that need to take place in the ecosystem for disruption to occur.
1. BACKGROUND
Multiple trends point to the need for personalized investment solutions that account for the unique funding requirements to meet an individual’s goals. Most investment theory, however, is based on and works well for institutional investing. The needs of individual investors differ significantly from institutions. There are some obvious differentiating factors:
- Individuals do not exist in perpetuity
- Individuals have liquidity constraints
- Individuals have constraints related to individual goals
Goals-based wealth management has gained prominence as one approach to deal with these differences. The approach has been largely focused on the behavioral aspects of investing and gained momentum when Das/Markowitz/Scheid/Statman published their paper entitled Portfolio Optimization with Mental Accounts.2 That research led to a confirmation that if separate portfolios are built for different goals along the efficient frontier, the combined portfolios are consistent with Modern Portfolio Theory and do not lose efficiency. This was the first research that combined Modern Portfolio Theory with a useful client- oriented framework enabling investors to “bucket” goals into different mental accounts. The paper has been widely quoted in multiple articles related to Goals Based practice.
Wealth management firms have started making process and technology changes to align with goals-based approaches over the last decade. These changes were covered in 2014–2015 MMI Industry Guide to Managed Investment Solutions – Trends and Statistics.
2. THE MISSING CONNECTION
Franklin Templeton noted that while goals-based planning was gaining credibility as an advisory practice, the underlying investment portfolios remained risk-based and aligned with investor risk tolerance versus engineered toward goal success. This was confirmed by Franklin Templeton’s research in our paper A New Approach to Goals-Based Wealth Management, published on June 27, 2018.3 One of the most important tasks for a financial advisor is to listen to their clients and help them achieve their investment goals. However, while financial advisors understand the importance their clients place on saving and investing towards a goal, our research with iQity Research & Insights revealed financial advisors lack the tools or framework to translate their client’s needs and wants into portfolio strategies that will provide them with the best chance of success. In other words, they may start with detailed questions to identify and articulate client goals but then recommend a finite number of standard asset allocation models. Often, the client is placed in a portfolio or allocation that aligns with their risk tolerance and goal horizon but that does not account for the importance of the goal or the likelihood that they will achieve it. Portfolios intended to be personalized are instead grouped and, are often rebalanced periodically to the target asset allocation regardless of market conditions. Moreover, underfunded goals are often ignored, and critical goals may be over-funded.4
When it comes to evaluating the success of the portfolio or strategy, Advisors typically use standard financial industry performance indicators such as excess returns, alpha, tracking error etc. vis a vis a benchmark, rather than probability of attaining a goal. Focus on individual investments instead of the overall goal of the portfolio leads to confusion on part of the client and suboptimal portfolio strategies. Another research study with Hall and Partners showed clients gravitate towards goals-based probability language such as “Based on your current strategy, there is a 90% chance that you will achieve your investment goal,” a view that was very clear to 49% of clients and either very clear or quite clear to 92% of clients. Compare this with individual investment-oriented language such as “Your U.S. equity investment has been outperforming its benchmark index,” which was only very clear to 29% of clients and either very clear or quite clear to 71% of clients.5
Goals-based planning is not the same as goals-based investing.
While both may start with a goals conversation, the definition of risk and execution is different. The risk-based approach equates risk with portfolio volatility. It is inherently a tactical measure. The goals-based approach that we propose equates risk with not attaining a goal. This is an outcome and more client-centric measure. And, it has a big impact both on how portfolios are managed, and how their performance is measured.
END NOTES
1. 2018 Harry Markowitz Award for S.R. Das, D. Ostrov, A. Radhakrishnan, D. Srivastav (2018). A New Approach to Goals-Based Wealth Management, Journal of Investment Management 16(3), 1–27.
2. S.R. Das, H. Markowitz, J. Scheid, M. Statman, (2010). Portfolio Optimization with Mental Accounts, Journal of Financial and Quantitative Analysis 45(2), 311–334. 3. S.R. Das, D. Ostrov, A. Radhakrishnan, D. Srivastav (2018). A New Approach to Goals-Based Wealth Management, Journal of Investment Management 16(3), 1–27.
4. Franklin Templeton partnered with aQity Research & Insights, Inc. to conduct qualitative research from September–December 2017. Independent qualitative research was also conducted over the same period.
5. Franklin Templeton partnered with Hall and Partners to conduct this survey of 300 advisors and 503 investors in May 2017.
