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[Book Summary] Goals-based Investing – A Visionary Framework for Wealth Management

Goals-Based Investing (2022) explains how the wealth management industry is transforming, how modern portfolio theory is no longer considered modern, and how product evolution and regulatory changes are making it easier for investors and advisors to access market segments that were once the exclusive domain of large institutes.

[Book Summary] Goals-based Investing - A Visionary Framework for Wealth Management

Content Summary

Genres
Introduction: What’s in it for me? Learn why goals-based investing is the future of the financial-services industry.
The financial services industry is in a state of continuous evolution.
Goals-based investing is an antidote to the limitations of modern portfolio theory.
Advisors and investors need to be aware of their cognitive biases and how these may affect their investment decisions.
Even after the rise of passive investment, active management has its place.
Alternative investments and sustainable investing are becoming attractive options.
Goals-based investing requires an analysis of what you want to achieve through investment.
Successful wealth advisors must navigate and adapt to the changes coming over the next ten years.
Final summary
About the author
Table of Contents
Overview
Review/Endorsements/Praise/Award
Video and Podcast
Read an Excerpt/PDF Preview

Genres

Money and Investments, Business, Finance, Derivatives Investments, Bonds Investing, Private Equity, Analysis, Strategy

Introduction: Learn why goals-based investing is the future of the financial-services industry.

The financial-services industry has been changing over the last decades to serve investors better. Failure by financial advisors to understand and adapt their approach to these changes will ultimately have an impact on their success.

So let’s take a whistle-stop tour of how the industry has been changing, discuss why modern portfolio theory and its successors are flawed, examine active and passive management, define what alternative investment actually means, present goals-based investment as a way to meet the objectives of high-net-worth families, and look at some predictions for the industry’s future. That’s a lot to get through, so let’s get started.

Keep in mind that this is not financial advice. Rather, it’s an analysis of the past, present, and possible future of the wealth-management industry, and how you can be better prepared for it.

In this summary, you’ll learn

  • why there is a place for both passive and active investment management;
  • about the role of alternative investment strategies; and
  • how to establish a goals-based investment portfolio.

An advisor’s value proposition

The financial services industry is in a state of continuous evolution.

Whether you’re a seasoned investor or relatively new to the topic, you might not know exactly who the key players in the financial-services industry are, and how their roles in wealth management differ. So, let’s start with a quick overview.

First, there are wealth-management firms. These include companies like Morgan Stanley and Merrill Lynch. Such companies carry out research and due diligence. They also provide support to financial advisors. The financial advisors themselves work for the wealth-management firms, advise clients directly, and may also use asset managers to provide investment advice. Then there are custodians. Examples include companies like Schwab and Fidelity. They provide custodial services, technology, research, and trading support. And finally, we have asset managers such as Blackrock, Fidelity, and JP Morgan. These companies manage money via mutual funds, exchange-traded funds (ETFs), hedge funds, and other structures.

Some of these companies also provide multiple services. For example, Morgan Stanley has retail and private-wealth divisions, but also has asset-management subsidiaries.

Over the last 20 years, the financial sector has changed considerably – and so has the relationship between the various companies within it. It’s also likely that it will change further over the coming decade.

Back in 1975, the founder of The Vanguard Group, Jack Bogle, created the first index fund. He was skeptical about the need for financial advisors and believed that investors could do just as well left to their own devices. Vanguard is now the second-largest asset manager worldwide with over $6 trillion in assets under management. After the general financial crisis, growth in do-it-yourself investment grew rapidly as investors began to question why they should use investment managers if they couldn’t protect them from market collapses. The use of ETFs accelerated after the crisis and advisors also began to use them more in building portfolios.

And then came COVID-19, the pandemic that stopped the world. It ushered in not only health issues but financial woes. The markets became very volatile and uncertainty reigned. Investors, shocked by rising death tolls, also watched helplessly as their wealth plummeted.

Over the years, wealth-management practices have also needed to reinvent themselves in order to provide new services to their clients. This has required reskilling and training in order for advisors to understand issues such as estates, tax management, lending options, and charitable giving, for example.

Financial advisors needed to help their clients through these troubled times, and in innovative ways – through the use of technology to reach their clients, for example. In a post-pandemic world, it is still unclear how financial advisors will engage with clients in the future. What is clear, though, is that they need to rise to the challenges that the sector faces now and in the coming decade, evolve their approach, or risk being replaced by robots and AI and ultimately becoming obsolete.

Goals-based investing is an antidote to the limitations of modern portfolio theory.

You might be familiar with the term modern portfolio theory, or MPT. This idea was developed by Nobel Prize–winner Harry Markowitz, who said that “diversification is the only free lunch in investing.” He posited that by combining risky investments which were not in lockstep with each other, greater returns could be achieved with much lower risk.

MPT, though, has its limitations. It assumes that all investors are risk-averse, whereas, in reality, not all investors will select the optimal, less-risky option. In fact, they are often chasing greater returns.

So what are the alternatives, and why is a goals-based approach more appealing?

In 1991, Post-MPT came along. It’s pretty similar to MPT but defines risk differently and also how the risk will influence expected returns. Then, in 1992, the Black-Litterman model arrived. This model is based on the premise that assets perform in the future just as they have in the past – or the equilibrium assumption.

These and other alternatives have drawbacks too. For example, post-MPT suffers from accuracy of data in the same way as MPT, as future results may not correspond with historical data. And the Black-Litterman model uses projections of future results, which actually may also be flawed.

The financial world has changed a lot since Markowitz published his paper, but Goals-based investing shifts the goalposts. Rather than concentrating on beating the market, maximizing returns, and minimizing risks, it concentrates on progress toward the investor’s goals and reinforces the idea of long-term investing. It balances risk and returns and seeks to achieve desired outcomes – whether that’s for capital appreciation, wealth preservation, savings for a second home, college funding, charitable donation, or retirement income.

Next, we’ll examine the roles of passive and active investment management and alternative investments – in particular, hedge funds and innovations in private markets – and then we’ll consider the rise of sustainable investing, before returning to discuss goals-based investing a little further on.

Advisors and investors need to be aware of their cognitive biases and how these may affect their investment decisions.

Investors don’t always act rationally. But why is that?

In a nutshell: cognitive biases. Many investors will do whatever it takes to avoid financial loss – a cognitive bias known as loss aversion. Or they may begin to believe that they’re capable of picking stocks or managers who will outperform the market – aka illusion of control bias. Then there’s recency bias, which makes one believe that strong results in the present can be extrapolated into the future. And herd mentality, where investors may pursue stocks because they’re suffering from FOMO – the fear of missing out.

So if investors suffer from all of these biases, what can the poor financial advisor do? Well, first and foremost they need to recognize that they themselves suffer from the same biases. Then, they need to remind clients of their goals and objectives, and advise them against acting on emotions and impulse. Here, it can help to have an investment policy statement that allows advisors to take action without permission and to do “the right thing” on behalf of their clients.

As an advisor, you should also be conscious of how you frame each discussion. Use simple language. Avoid jargon and confusing terminology. Try using an analogy or story when explaining complex topics. Clients will respond more positively if you give clear explanations.

Davidow uses an analogy when explaining asset allocation to clients: building a portfolio is like making an omelet. A good omelet requires the right ingredients in the right quantities. It includes eggs, cheese, onions, and then maybe mushrooms, sausage, or other tasty extras. Each ingredient, Davidow explains, is like an asset class. But not everyone will follow the same recipe. Some investors might exclude emerging markets from their portfolio – just as some people might exclude onions from their omelet.

Financial advisors are here to teach clients about financial markets and asset allocation. But if you want to increase your credibility and earn more respect, you should also teach them about behavioral finance. Clients need to know that they’re not alone in reacting to their emotions and that it’s not always easy to overcome irrational impulses.

Even after the rise of passive investment, active management has its place.

In 1973, in his book A Random Walk Down Wall Street, Burton Malkiel made a bold statement: “a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” His book began the debate about active and passive investment management and effectively kick-started the passive-investing revolution. Vanguard introduced the first index fund in 1975; later, in 1993, State Street Global Advisors launched the first exchange-traded fund, or ETF.

ETFs made it easy for investors to access the market cost effectively and tax efficiently. It meant that they could access the S&P 500 – that’s the Standard and Poor’s 500, a stock market index which tracks the performance of 500 companies on the US stock exchange – in a single trade without transaction costs and with built-in automatic rebalancing. Prior to this, it was a costly process and an investor’s exposure would inevitably deviate from the index over time.

There are now over 2,200 ETFs available in the US. They amount to some $6 trillion in assets under management. ETFs started out as cheap, efficient passive investing options. They both mimicked the market and provided affordable access to the market. Now they represent a range of smart options that use alternative weighting strategies, including factors such as value, size, quantity, volatility, and momentum. In other words, ETFs now offer advisors even greater flexibility when building portfolios for their clients.

But the rise in passive investment doesn’t mean there isn’t room for active management. Indeed, many successful fixed-income ETFs are actively managed, and there’s an active element to each. So the question really shouldn’t be whether active or passive investing is better but how active and passive strategies can be best used.

And large wealth-management firms are currently developing new asset-allocation models – models that use ETFs, mutual funds, and separately managed accounts (SMAs) as “building blocks.” These models provide benefits to both advisors and investors by aligning the interests of the advisors with those of their clients. Advisors get more expertise from asset managers, and investors get access to specialized teams of experts.

In spite of the new models, there’s always going to be a need for customization of portfolios to suit the specific requirements of some high-net-worth and ultra-high-net-worth families. This includes the use of so-called alternative investments, which we’ll explore next. The good news is that the industry now has a wide range of tools at its disposal to build appropriate portfolios to fully meet most clients’ needs.

Alternative investments and sustainable investing are becoming attractive options.

The term alternative investments often creates fear and confusion in investors. So let’s start by clearing up what the term actually means. Put simply, alternative investments means hedge funds and private markets – that’s private equity, private credit, and real assets. Hedge funds, though, aren’t available to everyone – only qualified purchasers and accredited investors. To be accredited, you need to have a net worth over $1 million or an annual income over $200,000. To be a qualified purchaser, you need at least $5 million in investments.

So why should we consider alternative investments in a portfolio? Well, there are three main factors to think about.

First, there’s the market environment. The next decade will be characterized by lower traditional equity returns and bond yields. The market will have to deal with the impact of the COVID-19 pandemic, assets with negative yields, rising inflation, and growing tension around the world. Alternative investments may help to dampen volatility, provide alternative sources of income, and perhaps even provide better returns.

Second, innovation in products has allowed managers to offer investors alternative strategies where previously access wasn’t possible due to requirements for accreditation and minimum investment values.

And third, it’s easier for privately offered funds to market themselves as a result of regulatory changes. For example, the Jumpstart Our Business Startups (JOBS) Act allowed crowdfunding to operate and also made it easier for hedge funds and private equity to be marketed directly to investors.

Let’s look more specifically at hedge funds. The first hedge fund was launched in 1949 by Alfred Jones – “the father of the hedge fund” industry. Jones used long and short stocks in equal proportion and his results required the right stocks to be bought and sold. By limiting the number of investors to 99 and using limited partnerships, he avoided the requirements of the Investment Company Act of 1940. Jones took 20 percent of the profit in compensation.

Today’s hedge funds retain many of the characteristics of Jones’s model. A partnership model is still used, and the fund manager is paid a percentage of the profits. The number of partners is limited, and, in the same way, long and short stocks are bought and sold. As part of a portfolio, hedge funds can often provide stronger returns and also protect capital through risk management.

Many investors are unaware that not all hedge funds are the same. For example, there are equity-hedge, event-driven, relative value, macro, and multi-strategy solutions which have their own mechanisms for asset management.

Now let’s turn our attention briefly to the innovations in private markets – private equity, private credit, and real assets. Once the domain only of large institutions, product innovation in recent years has also allowed these investments to become available to more investors.

There’s a whole spectrum of private-equity investment opportunities depending on where a company is in its development. For example, at one end of the spectrum, we have venture capital – an investment in an early-stage company that’s still in the process of developing its product or service. At the other end, there are buyout cash-flow-positive companies that may benefit from restructuring or from the sale of some assets. Private-equity managers can offer value by launching new products and services, spinning off noncore business, or making strategic acquisitions, for example.

Both advisors and investors need to understand the stages of development and the risks involved before investing in private equity. Investors need guidance from wealth advisors to answer such questions as: What role do private markets play in a client portfolio? How can the options be evaluated? And how much investment should I allocate to private markets?

Finally, let’s consider growth in sustainable investing. This has perhaps been the biggest trend across the financial industry, but many investors still believe that they have to give up returns in order to do good in their investment portfolio.

A number of terms are often used interchangeably. Socially responsible investing (SRI). Environmental, social, and governance (ESG). Impact investing. Sustainable investing. But they’re not the same.

Back in the 1990s, SRIs became popular as a way to express views about unpopular activities. If an investor disliked tobacco or alcohol, for example, companies or stocks could be excluded from a portfolio. But this often meant sacrificing returns.

On the other hand, ESG screening, which has become increasingly popular in recent years, assigns a weighting to companies with the best practices. Such strategies often outperform comparable unconstrained indices.

Impact investing concentrates on the allocation of funds to private companies which endeavor to deliver positive social and environmental impacts.

Sustainable investing, which is a broad umbrella that covers SRI, ESG, and impact investing, has grown considerably from $12 trillion in 2018 to $17.1 trillion in 2020. It accounts for nearly one-third of all US professional assets under management. Within this figure, the largest investment comes from public funds, amounting to approximately $3.4 trillion.

As sustainable investing becomes more and more mainstream, wealth advisors need to seize the opportunity it presents. Incorporating sustainable investing into clients’ portfolios may increase the probability of investors achieving their goals, and, in turn, advisors may reap the rewards of bigger dividends in the future.

Goals-based investing requires an analysis of what you want to achieve through investment.

Think for a minute about managing your family budget. Imagine you have a “pot” for your rent, another for the bills, another for the food for the week, a couple of others for other specific purposes, and finally – if anything is left over – one for vacation expenses.

Goals-based investing is pretty similar. Instead of a single investment pool, you separate your investments into different “pots,” each relating to a particular goal you wish to achieve. Your goals might, for example, include generating retirement income, creating a college fund for the kids, charitable giving, wealth accumulation, or other outcomes that fit your requirements. Each of your goals has different cash-flow needs and time horizons, so it makes sense to have multiple portfolios rather than just one.

Let’s imagine for a moment that you have a high-net-worth family client that’s interested in a goals-based-investment approach.

The first step in working with your client is one of discovery. It’s important to understand what the family needs and wants. What makes it unique? Then, an analysis of estate and trust issues is required. Does a trust already exist? Multiple trusts? How are assets to be distributed? Third, you need to understand the goals and objectives of the family. What needs are there to be solved? What are the cash-flow requirements and projected time horizons?

The fourth step is to develop asset allocations. Here, as in step three, you need to understand what the return objectives are, income requirements, and time horizons. When you have this information, the fifth step is to select the right investments. You’ll need to look for funds or managers who can provide the required outcomes considering ETFs, SMAs, registered funds, or private funds. How do you want to incorporate active and passive strategies? And do alternative investments play a part in the portfolio?

Finally, you’ll need to monitor progress toward goals. Keep track of how accounts are performing relative to their required objectives. And also be aware of changes in the family’s needs or circumstances in order to make any portfolio changes necessary. It’s important to evaluate the progress toward goals consistently.

Remember that the client’s portfolio may be a way to achieve desired outcomes, but this doesn’t mean you can ignore performance. You still need to adopt the best investment strategies possible. The assets within a portfolio are like pieces of a jigsaw puzzle. If you put the pieces together correctly, they form a clear picture – a picture of what the portfolio is intended to achieve. Put them together haphazardly and, well . . . that picture is less than clear!

When explaining investments to clients it’s useful to organize them into three groups: growth, income, and defense. Growth of the portfolio might come from equity allocation in large, small, international, and emerging markets. Income might come from treasury, corporate, or government bonds. And the inclusion of gold as an investment is to provide security and stability against market shocks – defense.

When engaging with a high-net-worth family, you may want to suggest that they develop a mission statement if they don’t have one already. This helps clarify what the family wishes to achieve and how it will pass on its values from generation to generation.

Successful wealth advisors must navigate and adapt to the changes coming over the next ten years.

Over the last ten years, there’s been a rapid change in the market and it seems inevitable that there’ll be further changes over the coming decade. So let’s conclude our whirlwind tour of wealth management and goals-based investing with a look at some predictions for what the next ten years hold for the industry.

Davidow believes that there will be a shift in demographics to younger, more diverse investors. He also predicts that goals-based investing will become the norm. McKinsey & Company shares his view, predicting that at least 80 percent of advisors will be offering goals-based-investment advice by 2030.

Let’s finish up by looking at three ways the industry may change in the next decade.

First, wealth advisors will differentiate themselves from the competition through education, and those with specialized training will be at a premium. Specialist educational organizations will have to provide continually evolving education programs to both advisors and their clients.

Second, commissions will continue to fall and eventually trading will become commission-free. Revenues will come from other sources such as from using affiliated products in model portfolios, revenue-sharing relationships with asset managers, and by lending securities. Of course, savvy investors will understand that commission-free doesn’t actually mean free.

And, third, artificial intelligence will learn more about client needs and behavior, and will help advisors understand which strategies will work best for their clients. AI will probably also help advisors anticipate client needs, improve outcomes, and even strengthen the relationship between advisor and client. But AI will always lack empathy – which is why it will never replace good wealth advisors.

Wealth-management advisors will need to adapt and respond to these changes and to the changing needs of their clients.

Changes are coming – great changes – and the successful wealth advisors will be the ones who can navigate and adapt to these changes by evolving their value proposition and how they serve their clients.

About the author

Tony Davidow, CIMA, is president of T. Davidow Consulting, an independent advisory firm focused on the needs and challenges facing the financial services industry. Davidow leverages his diverse experiences to deliver research and analysis to sophisticated advisors, asset managers, and wealthy families. He has held senior leadership roles at Morgan Stanley, Charles Schwab, Guggenheim Investments, and Kidder Peabody among others. He is focused on developing and delivering content relating to advanced asset allocation strategies, alternative investments, factor investing, sustainable investing, and other topics. In 2020, Davidow was recognized by the Investments and Wealth Institute, with the Wealth Management Impact Award, which honors individuals who have contributed exceptional advancements in the field of private wealth management.

Tony Davidow, CIMA | LinkedIn
Tony Davidow, CIMA | finStream.tv

Tony Davidow

Table of Contents

Acknowledgments v
Foreword ix
Introduction xiii
Chapter 1 The State of the Financial Services Industry 1
Chapter 2 The Evolution of Wealth Management 23
Chapter 3 Becoming a Behavioral Coach 49
Chapter 4 Challenging Modern Portfolio Theory 69
Chapter 5 Incorporating Active and Passive Strategies 89
Chapter 6 The Role and Use of Alternative Investments 109
Chapter 7 Innovations in Private Markets 129
Chapter 8 Sustainable Investing 151
Chapter 9 Goals-Based Investing 169
Chapter 10 The Future of Wealth Management 189
Notes 207
Index 211

Overview

Raise your investing game to a new level with the latest investing strategies, methods, and products

The wealth management industry has undergone a major transformation over the last decade, including increased concerns and skepticism from investors, the growth of robo-advisors, product evolution, and an evolving value proposition―in addition to geopolitical risks, increased correlation across asset classes, changing demographics, and social tensions. Concepts like “Modern Portfolio Theory” aren’t modern anymore, and even Post-Modern Portfolio Theory has become passé.

To succeed in today’s complex, uncertain world of investing, you need go beyond plain vanilla stocks, bonds, and mutual funds and embrace the latest investing tools and techniques. Goals-Based Investing is an unparalleled guide to:

  • The limitations of modern portfolio theory
  • Behavioral finance–overcoming biases
  • The role and use of alternative investments in building better portfolios
  • The growth of exchange-traded funds (ETFs) from “cheap beta” to “smart beta”
  • Sustainable investing, also known as environmental, social, and governance (ESG) investing
  • Adopting a goals-based investing approach
  • The future of wealth management

Investing products have evolved significantly over the past two decades, making it easier than ever for advisors and investors to access various segments of the market and unique asset classes.
Goals-Based Investing examines product evolution and discusses how to use these tools to achieve your goals. With this forward-looking, one-of-a-kind investing guide, you have everything you need to navigate the investing jungle, avoid landmines, and achieve your long-term goals and objectives.

T.Davidow Consulting | Website
Goals-Based Investing | YouTube

Video and Podcast

Goals-based Investing

Review/Endorsements/Praise/Award

“Tony Davidow has effectively captured the evolution of modern wealth management by focusing on the key determinants of financial success. This gem is a must-read for both financial advisors and individual investors.” – John Nersesian, CIMA®, CFP, CPWA, Head of Advisor Education, PIMCO Investments

“With this book, Tony Davidow strikes the perfect balance of explaining success in wealth management as both an ‘art’ and a ‘science.’ He carefully threads the needle with advice, anecdotes, and wisdom that will inspire financial advisors everywhere.” – April Rudin, Founder and CEO, Rudin Group

“I have known Tony Davidow professionally for 20+ years and know him to be a thought leader on the topics of goals-based investing, alternative investments, ESG, and behavioral finance. I think this book is an essential reference source for any advisor who wants to better understand the current and future state of wealth management for high-net-worth families.” – Scott Welch, CIMA®, Board Member of the Investments & Wealth Institute

“I am seeing a growing number of institutional investors evolve their portfolios, moving assets into foreign markets, seeking to enhance the yield in their fixed income portfolio, and increasing allocations to alternative investments, such as private equity, real assets, and hedge funds. As high net worth investors and their advisors seek to upgrade their portfolios and emulate the success of institutional investors, Goals-Based Investing provides the rationale and roadmap to facilitate the journey.” – Keith Black, PhD, CFA, CAIA, FDP Managing Director, Content Strategy, CAIA Association

“True leaders do way more than just effectively lead—they educate, they motivate, and they lay a strong foundation for others to succeed in their footsteps. In the decade plus that I’ve personally experienced the leadership of Tony Davidow, he has embraced every one of these traits of leadership in the financial advisory universe. His new book is a fantastic, concise blueprint for how advisors need to evolve—a must-read for every A-list advisor.” – Kevin Sanchez, CIMA, CPWA, CFP, former Chair, Investments & Wealth Institute

“With each passing year, client expectations rise. Those that are not on a learning journey will find themselves left behind. Tony Davidow is a consummate teacher and well-equipped Sherpa who contextualizes the changing world of wealth management and provides pointed guidance to help advisors better serve high-net-worth clients.” – Christine Gaze, Founder & Managing Partner, Purpose Consulting Group

“After decades as an advisor to financial advisors and experience in working with institutional money managers and funds, Tony is sharing his knowledge and insights in long-term wealth management. Goals-Based Investing is a timely book for financial advisors wanting to succeed and address their client’s needs in the current market environment. Additionally, ‘do-it-yourself’ investors would benefit from reading Goals-Based Investing, with up-to-date information on market developments, techniques for asset allocation, and wealth management.” – Halvard Kvaale, Portfolio Manager, former Managing Director, Head of Manager Research and Due Diligence, National Broker-Dealer

“The wealth management industry is undergoing a secular shift from product to advice. In this context, Tony Davidow captures the evolution of the advisor/client dialogue as it has moved beyond ‘the money’ to a host of non-investment needs. Goals-Based Investing is equally useful for investors who are often confused by their choices of products and advisors and for advisors who need to deliver much more than investment returns to meet their clients’ idiosyncratic objectives.” – Jamie McLaughlin, CEO, J. H. McLaughlin & Co., LLC

“In his book Goals-Based Investing, Tony Davidow fuses the diverse landscape of investing into one succinct and comprehensive treatment to help investors navigate the world of wealth management. Whether you are a financial advisor or DIY investor, you will find relevant insights to help build and manage portfolios. From behavioral finance, to alternative assets, to sustainable investing, and more, Davidow covers it all.” – Margaret M. Towle, PhD., CIMA®, CPWA®, Yakima River Partners, LLC

“Goals-Based Investing is a must-read for fiduciaries and advisors. Tony Davidow uncovers financial myths, discloses the market realities, and everything in between. Tony takes us on a journey exploring the evolution of the wealth management industry.” – Alan Reid, Founder and CEO, rPartners

“Tony Davidow was my original teacher and mentor on all things investing as I was coming up in financial services. He taught by showing, not just telling. He does not talk down to the retail investor. Yet he manages to help them meaningfully elevate their understanding of investing and leverage its benefits to help meet their goals.” – Lule Demmissie, President, Ally Invest

Read an Excerpt/PDF Preview

Goals-based investing addresses some of the limitations of modern portfolio theory (MPT) and blends attributes of behavioral finance, to solve for investors’ needs, wants, and desires. In this article, I frame the merits of goals-based investing, discuss how wealth advisors can incorporate it into their process, and provide a case study to bring the concept to life.

MPT has helped advisors and investors understand the advantages of diversification by minimizing risk, with the correlation across asset classes serving as the “secret sauce.” However, MPT is built on several flawed assumptions, including the notion that investors are rational and will select the optimal portfolio. MPT also relies upon historical return, risk, and correlation data to design the optimal combination of asset classes to either maximize returns for a given level of risk or minimize the risk for a desired level of return.

But what if equity returns and bond yields are lower in the future? What if the correlations across asset classes remain elevated? Unfortunately, using flawed or outdated data may mean that investors fall short of both their return and income requirements. This is precisely the environment we find ourselves in, with capital market assumptions projecting substantially lower returns and income over the next 10 to 20 years. Correlation data has been steadily rising due to the interconnectivity of the global markets.

MPT is mathematically driven, with the inputs determining the outputs. Behavioral finance is emotional, focusing on how investors respond to stimuli. Mean-variance optimization is designed to maximize returns for a given level of risk or minimize the risk for a given return target and has certain built-in limitations, including the viability of the inputs.

Goals-based investing recognizes that investors are often solving for multiple goals simultaneously and maximizing returns may not be one of those goals. This investing strategy moves the wealth advisor’s discussion from outperforming the market to achieving client goals while aligning the portfolio allocation to those specific goals.

Goals-based investing is designed to increase the likelihood of achieving life goals: accumulating wealth, generating income in retirement, saving for college, giving to charities, or some other specific outcome. Affluent families pass on wealth from generation to generation through trusts, and they often fund numerous charitable activities. They may have multiple account types with different goals and objectives for each. Goals-based investing also provides the flexibility of solving for multiple goals across multiple portfolios.

Goals-Based Wealth Management

Goals-based wealth management marries financial planning and investment planning, providing a road map for investors in achieving their goals. It begins with the discovery process, trying to understand the HNW family’s objectives. Where the traditional approach is to solve for multiple family needs in one portfolio, goals-based investing provides a framework for solving multiple goals, with different cash-flow needs and time horizons, with multiple portfolios. The goals-based wealth management process considers the various family goals.

Discovery Process: What are the family’s needs and wants? What are the various account types? What is unique about each account type?

Reviewing trust and estate issues: What types of trusts have been established (living, revocable, irrevocable, generation skipping, etc.)? How are assets distributed? Who receives them (children, grandchildren, charity, etc.)?

Establishing goals and objectives: What are you solving for (per account type)? What are the cash-flow needs and various time horizons?

Developing asset allocations: What are the return objectives for each account type, the income requirements, the time horizon to achieve the various goals, and the liquidity requirements?

Selecting the right investments: Which fund or manager can generate the required outcome? What are the structural trade-offs among mutual fund, ETF, separately managed account, registered fund, or private fund? How should you incorporate active and passive strategies? What role do alternative investments play in this diversified portfolio?

Monitoring progress relative to goals: How are the managers and accounts doing relative to their stated goals? Have there been changes to the family’s circumstances? Do you need to make portfolio adjustments?

Advisors who adopt a goals-based wealth management process must be consistent in measuring progress relative to goals. They cannot fall into the trap of emphasizing performance in rising markets and goals-based investing in challenging environments. Their performance measurement tools need to evolve to report progress appropriately, rather than emphasizing performance relative to the S&P 500 or some other arbitrary benchmark.

The Means To The Ends

A client’s portfolio is the means to an end. It’s how their wealth grows over time and how they achieve their desired outcomes. Adopting a goals-based approach does not mean that wealth advisors should ignore performance, but rather change the utility function to solve for a family’s objectives. HNW families obviously want and expect access to the best investment strategies. However, if the top-performing strategies come with high volatility and high turnover, then their value may be negated on an after-tax basis.

If assembled correctly, portfolios can solve for specific goals, and if you properly understand the role of each investment, you can measure its effectiveness in the overall portfolio. As covered throughout my book Goals-Based Investing, I tend to think of asset classes as puzzle pieces. If they fit together well, they provide a clear picture of what the portfolio is designed to do. If they are put together in a haphazard fashion, the portfolio’s purpose will not be clear.

If they are put together in a haphazard fashion, the portfolio’s purpose will not be clear.

To help clients understand the role of various investments in their portfolio, I like to use puzzle pieces to illustrate the individual role of each investment, and how they need to come together. This puzzle piece analogy works well with clients because it helps demystify the individual investments and establish their role in a diversified portfolio. It is more intuitive for clients if we frame the investments in terms that they understand, such as growth, income, defense, and inflation hedging.

This framework establishes a more effective way of measuring each investment’s success and failure. Commodities like gold are not in a portfolio to outperform the S&P 500. They are a defensive asset, included in a portfolio to provide safety and stability in the face of market shocks and help hedge the impact of inflation. Fixed income, as the name suggests, is designed to generate income in portfolios, and equity-oriented strategies are focused on generating growth.

This framework also makes it easier to include complex investments like alternative investments. Alternatives are valuable and versatile tools, but they can be confusing for investors to understand. Using this framework simplifies the discussion considerably by putting the investment into terms investors understand.

By framing the asset class discussion like this, advisors can move investors from benchmarking everything to the S&P 500 in rising markets and to cash in falling markets. HNW families may own many of the same asset classes across account types but may weight the accounts differently to achieve the various goals. A trust established for grandchildren may be more growth-oriented because of their long time horizon. The patriarch’s retirement account may be geared toward generating income, and the personal account may be more defensive, based on their views of the prevailing market environment.

Family Goals

Wealthy families are typically solving for multiple goals simultaneously and are not focused solely on maximizing returns. Their objectives may include preserving wealth, transferring wealth efficiently, and funding causes that matter to the family. A family’s wealth may determine priorities, and it may be instructive to review the hierarchy of financial needs.

  • Cash-flow needs. Meeting the basic needs for food and shelter.
  • Financial safety. The ability to create a financial cushion for unforeseen events.
  • Accumulating wealth. Building wealth, saving for retirement, and paying down debt.
  • Financial freedom. Adequate savings for retirement, children’s educations, and vacations.
  • Legacy. Focused on estate planning, tax planning, charitable giving, and instilling value in children and grandchildren.

A family may be solving for various needs simultaneously. A family’s personal account may be focused on accumulating wealth, their retirement accounts focused on financial freedom, and their trusts established for legacy purposes.

Case Study

Tom and Patricia Morgan have two children, Charlie and Samantha. Tom and Patricia have recently retired, they have $5 million in savings and no debt. Charlie and his wife Lisa have two children ages 13 and 15 years old. Charlie is an architect and Lisa is a nurse. They have $1 million in savings and are focused on saving for the children’s college expenses and traveling with the family. Samantha is a single mother, with $500,000 in savings, and a young daughter with special needs. Tom and Patricia have set up trusts for the children and grandchildren to help them achieve their respective goals.

Case Study in Goals-based Investing

An advisor might treat this family as a single relationship, but their respective goals and objectives will be very different depending upon the respective dollar amounts, cash-flow needs and time horizons. A family shouldn’t be defined by their wealth. Each account should have its own goals and a customized portfolio designed to meet those goals.

Incorporating Goals-Based Investing

Working with HNW families requires a broader set of capabilities, moving beyond the portfolio. Wealth advisors need to evolve their practices to better meet the growing needs of these investors, evolving from selling products to solving needs, and expanding capabilities to include trust and estate issues, dealing with concentrated positions, lending, charitable giving, and tax management. Goals-based wealth management provides the framework for addressing these needs.

Wealth advisors should adopt a goals-based wealth management approach to solve the needs of HNW families, changing their relationship and value proposition to better align with the family’s goals. HNW families have complex needs, and goals-based wealth management is designed to identify them and then deal with them individually. Goals-based wealth management is the preferable model for both wealth advisors and HNW families.

Goals-based investing provides a road map for families large and small. Some families may be more focused on intergenerational wealth transfers, and others may be more focused on retirement planning. Some may be focused on charitable giving, while others are solving for college funding. Typically, HNW families are solving for multiple needs simultaneously, and their portfolios should be tailored to meeting each goal.

Wealth management is an ever-evolving set of disciplines. The one constant is serving the needs of families. Larger families often have more complexity and may require specialized team coverage. Wealth management is a multigenerational endeavor; therefore, it is incumbent on the advisor to develop relationships with the whole family to effectively deal with the inevitable wealth transfer challenges to come.

Key Takeaways

Goals-based investing is designed to identify and solve for multiple goals simultaneously. Rather than merely optimizing a portfolio to maximize returns or minimize risks, goals-based investing recognizes that HNW families have multiple goals, with different cash-flow needs, and different time horizons to achieve them.

A goals-based wealth management process provides the framework for achieving various goals across family accounts and developing the appropriate solutions for each account. Family goals are typically geared toward life events like transferring wealth, college funding, and charitable giving, each of which requires a dedicated focus to achieve the desired outcome. Affluent families are increasingly considering sustainable investing, aligning their portfolios and purpose, and wealth advisors need to understand and respond to this growing trend.

Wealth advisors need to engage all HNW family members and develop relationships with children, siblings, and other trusted advisors. A few tactics to engage wealthy families include engaging the children, educating the family, conducting family meetings, developing personal relationships and developing a family mission statement.

In this article, I examined the limitations of traditional finance, including MPT, and discussed behavioral finance and the inherent biases that we all exhibit. MPT assumes that investors are rational and will select optimal portfolios; it assumes that the future will be like the past. Not all investors seek to maximize returns or minimize risk. Most investors are solving for multiple goals with different time frames to achieve those goals. Goals-based investing is a more appropriate way of solving for client needs, marrying attributes of MPT and behavioral finance.

In this article, I suggested framing the investment discussion in terms of the role that the various investments play—growth, income, defense, and inflation hedging. A HNW family may use similar investments across their various accounts, but the weighting of the investments will vary based on their respective goals, cash flow needs, risk-tolerance, and time horizon, among other issues.

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