Journal of Financial Planning: October 2016
Robbie Cannon is president and CEO of Horizon Investments LLC, a goals-based investment management firm that specializes in active asset allocation, risk mitigation, and retirement income solutions.
The value of goals-based investment management is becoming increasingly important to financial advisers—as well as to the ever-more-sophisticated investors they serve.
The fact is, your clients won’t be too concerned about the amount by which their portfolios underperform or outperform the broad financial indices if they ultimately fail to achieve the key life goals they have set out for themselves and their families.
Goals-based investment management recognizes that fact and offers strategies aimed to create ideal financial outcomes for clients—results that are not only tied to investors’ real-world needs and objectives, but also help overcome their biggest real-world financial risks.
The Fatal Flaw of Emphasizing Risk when Building Portfolios
To see the value that goals-based investment management can bring to the table, it’s important to first acknowledge the limitations inherent in current-day portfolio design.
Modern portfolio theory concepts and portfolio optimization drive the construction of most portfolios. The objective is to create a series of model portfolios that fall on various points of the efficient frontier. It then becomes the financial adviser’s job to assist clients in choosing the specific efficient portfolios that are most appropriate for their financial situations.
Of course, it makes sense to seek portfolio efficiency, but there’s often a problem with the execution of that goal. The process is typically informed by various types of questionnaires designed to assess investors’ risk and return requirements and/or preferences. In most cases, the questions focus on identifying the amount of downside volatility investors can withstand without throwing in the towel on their investment strategy.
The upshot: downside volatility and short-term risk considerations are driving long-term portfolio allocation decisions instead of what really should be driving them—the goals that investors have throughout their lives.
The result is a disconnect. Typically, investors who go through the questionnaire process tell their advisers they’d like the highest rate of return with the lowest risk, and the result is often a traditional, balanced portfolio allocation (along the lines of 60 percent stock/40 percent bond, for example). Some advisers may assume that this balanced mix, designed around short-term loss tolerance, will enable clients to stay committed to their plan through a full market cycle and not engage in panic selling.
That’s the theory. But we all know the reality. When markets don’t act as we want them to, many clients lose faith and abandon their plans—needlessly jeopardizing the future growth potential of their assets. As anyone who has ever seen the well-known annual Dalbar data knows, investors’ returns fall far below the returns of their underlying investments. And one big reason is that portfolio design doesn’t focus on what truly matters: goals.
The risk/return questionnaire approach to building portfolios may further hinder goals-based investors by focusing mainly on just one stage of their life cycle—accumulation—instead of the entire journey. Portfolios built around that one need (using sometimes simplistic questions to assess that need) may not be accurately calibrated to address investors’ needs as they evolve over time and as they transition to new financial stages like protection and distribution. As a result, investors may end up in catch-all 60/40 portfolios that aren’t designed to address their individual, nuanced scenarios across their lifetimes.
Why Goals-Based Portfolio Construction Makes Sense
A goals-based approach to investment management doesn’t let short-term risk dominate the decision-making process. Instead, it seeks to make portfolio decisions that reflect the actual stages that investors go through in their own lives—from accumulation toward life goals (the “gain” stage), to the preservation of those goals (the “protect” stage), to distribution (the “spend” stage).
Rather than make short-term volatility the paramount driver of asset allocation decisions, goals-based portfolio design emphasizes the two factors that are often most important to investors in the real world: (1) time horizon—the amount of time they have to reach their goals; and (2) probability of success—the likelihood of having the capital they need to make their goals a reality.
This, then, is the essence of goals-based investment management—investing across a person’s entire life cycle to meet the primary objectives of that investment capital, with a focus on time horizon and the likelihood of success.
For example, consider a client who has a limited time horizon until he needs to start funding a goal. He will need a combination of asset classes that delivers very low volatility, of course. Conversely, a client with a defined goal that is 20 or more years away from actualization will likely benefit most from a combination of asset classes capable of generating the highest rates of return over that defined period—regardless of the volatility that may accompany that portfolio.
Managing Risk Within a Goals-Based Portfolio
Just because volatility doesn’t belong in the driver’s seat doesn’t mean it shouldn’t be a key consideration. As an investor begins to accumulate enough capital to achieve his or her goals and/or approaches the time when that capital needs to be readily available—the investor who is five years from retiring, for example—risk mitigation becomes increasingly important.
Here again, the differences between a goals-based approach to risk management and that of more traditional strategies can offer important advantages to investors. For example, risk mitigation tools can be used within the equity portion of a portfolio to dampen volatility. When the stock market declines, an equity-based wealth protection strategy might gradually shift a portfolio toward investments that are less sensitive to severe market corrections. When those risk conditions have eased, the portfolio is gradually shifted back toward its growth-oriented position. Indeed, this is exactly what we have been doing with our portfolios during the challenging market environment so far this year.
Clearly, this is a different approach than simply bulking up on fixed-income and cash-based investments as a client approaches his or her goal. Mitigating risk within the equity portion of the portfolio can allow clients to maintain a higher exposure to stocks over time—giving them the potential to continue earning higher rates of return than they could get from an increasingly bond-heavy portfolio.
That ability to stay invested in equities for longer periods can significantly increase clients’ probability of their wealth lasting throughout what may be long, active—and expensive—retirement years.
Adding Real Value
Investment management that focuses on the goals that truly matter to investors—such as their ability to fund their needs, live the lives they want, and ensure that their wealth lasts at least as long as they do—adds tremendous value and helps differentiate those advisers who bring these capabilities to their clients. In the years and decades ahead, goals-based investment management will come to define the very best that our profession has to offer.