Goals-based Approach

A goals-based asset allocation process combines into an overall portfolio numerous sub-portfolios, each designed to fund a single goal within its time horizon and required probability of success.

Individuals have unique needs that differ from those of institutions. The critical difference is that individuals often have multiple objectives, each with its timeline and level of importance, which can be expressed as a specific probability of success.

These goals may not always be compatible, either because the individual may not have the financial assets to achieve them all or because there may be internal conflicts between the goals.

Using a single set of investment objectives and ignoring the different timelines and probabilities of success for individual goals can result in a loss of detail and may not fully address the complexities of the investment problem. An approach that divides the problem into sub-portfolios can better address all of an investor’s goals. Still, it may require several iterations to ensure the portfolio is consistent and satisfactory.

There are two fundamental parts to a goals-based asset allocation process. The first centers on creating portfolio modules, while the second relates to identifying client goals and the matching of these goals to the appropriate sub-portfolios.

Asset Allocation Process Based on Goals

While most advisers will likely use pre-optimized model portfolios to create individual client portfolios, achieving a higher level of customization is possible by creating specific sub-portfolios for each client’s goals.

This approach, however, can become prohibitively expensive and may be necessary only for clients with highly differentiated needs and constraints. In cases where the client’s investment constraints are incompatible with the pre-optimized modules, the adviser may have to create client-specific modules. Nevertheless, standardized modules would suffice for most individuals, except those with complex situations requiring a fully customized approach.

To cover a full range of capital market opportunities, many multi-client advisers may opt to create a set of goal modules. Each module represents a different return-risk trade-off, providing clients with adequate choices to meet their goals. Collectively, these modules should appear to form an efficient frontier, even though it does not exist due to each module’s varying optimization constraints.

The main differences between modules are liquidity requirements, eligibility of asset classes or strategies, and return-risk trade-offs. The market portfolio may guide the intra-asset class allocation, but specific sub-asset classes or strategies may be selected even if the asset class seems inappropriate. For example, high-yield bonds may be held in an equity-dominated portfolio due to equity risk factor exposure. The fixed-income market portfolio might be limited to investment-grade bonds and possibly base-currency-hedged non-domestic investment-grade bonds.

The following passage describes a typical setup for a goals-based approach:

An investor aims to purchase a Swiss-style ski chalet in the Rocky Mountains upon retirement, likely in 30 years. The investor wants to invest with a minimum 75% success rate, and the chalet build would cost $4,500,000 in future dollars.

$$ \begin{array}{c|c|c} \textbf{Values (in %)} & \textbf{Portfolio A} & \textbf{Portfolio B} \\ \hline \text{Expected return} & 6.0 & 8.0 \\ \hline \text{Expected standard deviation} & 5.0 & 7.0 \\ \hline \textit{75% Success Rate} & & \\ \hline \text {30-year return} & 4.3 & 4.9 \\ \hline \textit{90% Success Rate} & & \\ \hline \text{30-year return} & 3.9 & 4.4 \end{array} $$

Defining the Goals of the Client

Individual investors have different priorities when it comes to their financial goals. Some have well-defined goals, while others focus on a few urgent ones and keep the rest in the background. These goals may not always be achievable with the available financial assets.

Goals can be distinguished between those with anticipated cash flows and “labeled goals” with less precise details. Labeled goals have certain investment features in mind, but the actual need behind each label is not articulated. For cash flow-based goals, the time horizon is usually easy to determine, but the urgency of the goal and the required minimum probability of success are more complex.

The adviser can serve the client by preserving a human tone in advisory conversations and dividing the goals into “needs, wants, wishes, and dreams” to understand their urgency. A parallel structure can be created for goals one seeks to avoid: “nightmares, fears, worries, and concerns.” Commonly accepted everyday words can guide the discussion of probability level to ensure internal consistency.

An overview of issues related to goal-based asset allocation

Goals-based asset allocation is a mathematically sound way to deal with individual circumstances, but it is not a cure-all. It best suits individuals with multiple goals, time horizons, and urgency levels. Traditional financial tools can handle the classic example of a professional just starting to save for retirement with no other significant goal.

One should be careful to ensure that a single retirement goal is not made up of several elements with different levels of urgency and time horizons. The goals-based asset allocation process can help even when there is only one goal by considering several similar goals over successive periods with different required probabilities of success. This approach can be seen as a conceptual analog to the dollar-cost-averaging investment framework. For example, contributions made in the first few years might require a lower risk profile due to the potential impact of adverse market circumstances on the client’s willingness to stay with the program.

Goals-based asset allocation suits multiple goals, time horizons, and urgency levels. A multi-goal approach can help investors understand trade-offs. The ratio of cash outflows to assets is more important than the overall size of the asset pool.

Goals-based wealth management advisers face a higher level of business management complexity. They need to develop individual policies for each client while satisfying regulatory requirements and treating all clients equally. A systematic approach to decision-making can help advisers formulate individual policies that reflect their investment insights.

Overview of advisory for wealth management based on goals

1. Firm-wide process:

   $$ \begin{align*} &\text{Capital Market Expectations}+\text{Client goal definition}\\ &+\text{Asset(Strategy)Constraints}
   \\& =\text{Goals Based Modules} \end{align*} $$

2. Client process:

   $$ \begin{align*} &\text{Specific client goals}+\text{Assets needed for each goal} \\ &+\text{Goal based modules} \\ & =\text{Specific Client Allocation} \end{align*} $$

3. Firm-wide process:

   $$ \begin{align*} &\text{Specific client allocation}+\text{Tactical view of opportunities} \\ &+\text{Portfolio tilting model} \\& =\text{Specific Client Tilted Portfolio} \end{align*} $$

Question

Which portfolio would the analyst most likely choose for the ski chalet investor?

1. Portfolio A.
2. Portfolio B.
3. None of the above.

Solution

The correct answer is B:

Portfolio B has the highest expected return at a 90% success level over 30 years (4.9%). The investment amount would be $1,071,390.69 today to accumulate $4,500,000 at a 4.9% discount rate upon the target retirement date. 

A and C are incorrect. Portfolio A has a lower expected return at a 90% success level over 30 years (4.3%) in comparison to Portfolio B.

Reading 5: Principles of Asset Allocation

Los 5 (m) Recommend and justify an asset allocation using a goals-based approach