Goal-Based Investing… Or When The End Justifies The Means!

Traditional asset allocation optimises the structure of a portfolio based on an overall approach. Although it usually suits the needs of institutional investors, it is not necessarily adapted to a private investor, who tends to fragment his accounts and set up different portfolios corresponding to different needs.
 

In the same way, institutional investors generally measure risk by volatility (a statistical value which measures the standard deviation of returns) or more complex indicators, such as the Value at Risk, the conditional Value at Risk or the maximum drawdown. However, are these measures relevant to individuals? Couldn’t we rather define risk more intuitively, or more simply, as the probability of missing a goal? Volatility is obviously a very useful indicator which shows the risk of a portfolio, but it certainly does not indicate whether or not the goals have been met.
 

Let’s look at some practical examples.  A pension fund constructs its overall asset allocation with the objective of honouring its liabilities to retirees, i.e. there is just one objective. On the other hand, a private investor can set several goals and choose different investment periods, because his goal is not only about maximising the value of his assets over time.

For example, his goals might be the following: maintain the same standard of living (planning for retirement, or in the case of an entrepreneur, anticipating the sale of his business), buying real estate, paying for his children’s education, passing on a proportion of his wealth, setting up a philanthropic foundation, covering unplanned financial needs, etc.  Each of these goals will make up a specific portfolio.
 

Thus, each goal will be assigned an amount, an investment period, a level of risk and an order of priority:
 

• For example, for an individual, maintaining his standard of living is usually more important than buying real estate, which in turn is more important that succession planning, but these 3 goals are not mutually exclusive;
  
  
• Consequently, out of €1,000, an investor might decide to allocate €500 to his standard of living, €300 to the purchase of real estate and finally, €200 to succession planning.
   

Once this breakdown by portfolio has been determined, the next step is to build a suitable asset allocation for each one.

If the goal of a portfolio is to “preserve the standard of living—usually the top priority—we would recommend an allocation of very low-risk assets (e.g. life insurance). In this way, based on an appropriate tax position, sufficient annual income will be generated to maintain the investor’s standard of living, either through a recurring return of the portfolio or a regular distribution of capital, until the portfolio is terminated.
 

For each of the 2 other portfolios which concern respectively the “real-estate project” and “succession planning” goals, the relevant optimal allocation will of course be specific and different from the previous one, to include fairly risky assets that are fairly vulnerable to certain economic factors, fairly liquid, and in fairly large proportions.


At the end of the day, thanks to these 3 portfolios, the investor will have a clear and structured view of his wealth management to help him monitor his assets more effectively and take informed decisions.
 

Today, there is a growing interest in goal-based investing (developed by Statman in 2000 and subsequently by Brunel in 2003) because beyond the optimisation approach, it takes into account the specific and diverse issues of each investor, by spreading them over time and allocating a level of priority and risk to each one.

Furthermore, by structuring the investment process in a methodical way, it also helps to avoid more errors due to cognitive biases or emotional reactions, frequently observed among private investors. Indeed, it is important to keep in mind that decisions taken by an individual are not totally rational, an aspect covered by behavioural finance which applies psychology to finance and analyses the peculiarities of investment behaviour. This will be covered in a forthcoming article!