DEVELOPING GOALS-BASED ASSET ALLOCATIONS

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2562303/developing-goals-based-asset-allocations-1

DEVELOPING GOALS-BASED ASSET ALLOCATIONS

Learning Outcome

• recommend and justify an asset allocation using a goals-based approach

In this section, we review the concept of goals-based asset allocation, focusing first on the rationale behind this different approach and its investment implications. We then discuss the major elements of the process, illustrating them with specific, simplified examples when necessary. We conclude with a discussion of the applicability of the approach and its major shortcomings.

A goals-based asset allocation process disaggregates the investor’s portfolio into a number of sub-portfolios, each of which is designed to fund an individual goal (or “mental account”) with its own time horizon and required probability of success. The literature behind the development of this approach is very rich. Initially, goals-based wealth management was specifically proposed by a small group of practitioners,19 each of whom offered his own solution for taking into account the tendency of individuals to classify money into non-fungible mental accounts. Shefrin and Statman (2000) developed the concept of the behavioral portfolio, which can be related to the Maslow (1943) hierarchy of needs. Das, Markowitz, Scheid, and Statman (2010, 2011) showed that traditional and behavioral finance could be viewed as equivalent if one were prepared to change the definition of risk from volatility of returns to the probability of not achieving a goal.20 The essential point is that optimality requires both a suitably structured portfolio that can meet the given need and the correct capital allocation based on an appropriate discount rate, reflecting considerations of time horizon and the required probability of success.

Individuals have needs that are different from those of institutions. The most important difference is that individuals often have multiple goals, each with its own time horizon and its own “urgency,” which can be expressed as a specific required probability of success. Exhibit 30 summarizes differences in institutional and individual investor definitions of goals. An individual’s goals are not necessarily mutually compatible in two senses: The investor may not be able to address them all given the financial assets available, and there may be internal contradictions among the goals. An alternative process using one set of overall investment objectives—and thus effectively ignoring or “averaging” the different time horizons and required probabilities of success of individual goals—ostensibly loses the granular nature of client goals; as a result, the inherent complexities of the investment problem are less likely to be addressed fully. An approach that breaks the problem into sub-portfolios carries a higher chance of fully addressing an investor’s goals, although it may require several iterations to ensure that the investor’s portfolio is internally consistent and satisfactory.

Exhibit 30:

Institutional and Individual Ways of Defining Goals

	Institutions	Individuals
Goals	Single	Multiple
Time horizon	Single	Multiple
Risk measure	Volatility (return or surplus)	Probability of missing goal
Return determination	Mathematical expectationsa	Minimum expectations
Risk determination	Top-down/bottom-up	Bottom-up
Tax status	Single, often tax-exempt	Mostly taxable

a “Mathematical expectations” here means the weighted expected return of portfolio components.

The characteristics of individuals’ goals have three major implications for an investment process that attempts to address the characteristics directly:

• The overall portfolio needs to be divided into sub-portfolios to permit each goal to be addressed individually.

• Both taxable and tax-exempt investments are important.

• Probability- and horizon-adjusted expectations (called “minimum expectations” in Exhibit 30) replace the typical use of mathematically expected average returns in determining the appropriate funding cost for the goal (or “discount rate” for future cash flows).

Compared with average return expectations—the median or average return anticipated for a combination of assets that is appropriate to address a goal—minimum expectations reflect a more complex concept. Minimum expectations are defined as the minimum return expected to be earned over the given time horizon with a given minimum required probability of success.

To illustrate, assume that a portfolio associated with a goal has an expected return of 7% with 10% expected volatility and the investor has indicated that the goal is to be met over the next five years with at least 90% confidence. Over the next five years, that portfolio is expected to produce returns of 35% with a volatility of 22.4%.21 In short, this portfolio is expected to experience an average compound return of only 1.3% per year over five years with a probability of 90%; this result is quite a bit lower than the portfolio’s average 7% expected return (see Exhibit 31). Thus, rather than discounting expected cash outflows by 7% to compute the dollar amount needed to defease the goal over that five-year horizon, one must use a considerably lower discount rate and by implication reserve a higher level of capital to meet that goal. Under moderate simplifying assumptions, that computation is valid whether or not return and volatility numbers are pretax or after-tax. Exhibit 31 shows, for the case of a normal distribution of returns, a return level that is expected to be exceeded 90% of the time (the 40% of the probability that lies between the vertical lines plus the 50% to the right of the median).

Exhibit 31:

Probability-Weighted Return vs. Expected (= Median) Return

The Goals-Based Asset Allocation Process

Investment advisers taking a goals-based approach to investing client assets may implement this approach in a variety of ways. Exhibit 32 illustrates the major elements of the goals-based asset allocation process described in this reading. Ostensibly, there are two fundamental parts to this process. The first centers on the creation of portfolio modules, while the second involves identifying client goals and matching each of these goals to the appropriate sub-portfolio of a suitable asset size.

Exhibit 32:

A Stylized Representation of the Goals-Based Asset Allocation Process

Determining the lowest-cost funding for any given goal requires the formulation of an optimized portfolio that will be used to defease that goal optimally in the sense that risks are not taken for which the investor is not fairly compensated. Note that this process is most often generic and internal to the adviser and his or her firm. The adviser will typically not create a specific sub-portfolio for each goal of each client but rather will select, from a pre-established set, one of a few modules—or model portfolios—that best meet each goal.22 As discussed above, adjusting the expected return on that portfolio to account for the time horizon and the required probability of success allows one to formulate the relevant discount rate which, when applied to the expected cash flows, will help determine the capital required at the outset. That capital will then be invested in the optimized portfolio asset allocation, where the balance will decline until the end of the horizon, when it runs out.23 Note that the process is somewhat iterative because individual investors may describe a certain horizon as set when in fact they view it as “the next x years,” with the horizon rolling by one year every year. Note also that discounting needs based on probability- and horizon-adjusted minimum expectations naturally means that these expectations will be exceeded under “normal circumstances.” Thus, it is not unusual for the funding for a goal to seem excessive with the benefit of hindsight.

Although the great majority of advisers will likely create individual client portfolios using model portfolios—precisely, pre-optimized modules—a greater degree of customization is possible. Such customization involves creating specific sub-portfolios for each goal of each client. Indeed, it is conceivable, and mathematically possible, to create an optimal sub-portfolio for each goal. In fact, in practice, one would often proceed in this way when dealing with complex situations and with clients who have highly differentiated needs and constraints.24 The adviser may find it impossible to use pre-optimized modules if the investment constraints imposed by the client are incompatible with those used in the creation of the module set. These might include, for instance, geographical or credit emphases—or de-emphases—that conflict with the market portfolio concept. Other restrictions might concern base currency, the use of alternative strategies, or the acceptability of illiquid investments, for example. Thus, although it is feasible for advisers to create client-specific modules, this approach can become prohibitively expensive. In short, one would likely use standardized modules for most individuals, except for those whose situation is so complex as to require a fully customized approach.

Many multi-client advisers may prefer to create a set of “goal modules” whose purpose is, collectively, to cover a full range of capital market opportunities and, individually, to represent a series of return–risk trade-offs that are sufficiently differentiated to offer adequate but not excessive choices to meet all the goals they expect their clients to express. These modules should therefore collectively appear to create a form of efficient frontier, though the frontier they depict in fact does not exist because the modules may well be based on substantially different sets of optimization constraints.

The two most significant differences from one module to the next, besides the implied return–risk trade-offs, are liquidity requirements and the eligibility of certain asset classes or strategies. Additionally, while intra–asset class allocation to individual sub–asset classes or strategies may typically be guided by the market portfolio for that asset class, one can conceive of instances where the selection of a specific sub–asset class or strategy is justified, even though the asset class per se may seem inappropriate. For instance, one might agree to hold high-yield bonds in an equity-dominated portfolio because of the equity risk factor exposure inherent in lower-credit fixed income. Conversely, the fixed-income market portfolio might be limited to investment-grade bonds and possibly the base-currency-hedged variant of non-domestic investment-grade bonds. We will return to the construction of these modules in Section 17.

Describing Client Goals

At this point, it is important to note that individual investors do not always consider all goals as being equal and similarly well-formulated in their own minds. Thus, while certain investors will have a well-thought-out set of goals—which may at times not be simultaneously achievable given the financial assets available—others will focus only on a few “urgent” goals and keep other requirements in the background.

Thus, a first step is to distinguish between goals for which anticipated cash flows are available—whether regularly or irregularly timed across the horizon or represented by a bullet payment at some future point—and those we call “labeled goals,” for which details are considerably less precise. The term “labeled” here simply means that the individual has certain “investment features” in mind—such as minimal risk, capital preservation, purchasing power preservation, and long-term growth—but has not articulated the actual need that stands behind each label. The individual may already have mentally allocated some portion of his or her assets, in currency or percentage terms, to one or several of these labels. For cash flow–based goals,25 the time horizon over which the goal is to be met is usually not difficult to ascertain: It is either the period over which cash outflows are expected to be made or the point in time at which a bullet payment is expected. More complex, however, is the issue of the urgency of the goal and thus of the required minimum probability of success.

By working to preserve a human (as opposed to a technical) tone in the advisory conversations, the adviser can serve the client without forcing him or her to come up with a quantified probability of success. The adviser may start with the simple observation that there are two fundamental types of goals: those that one seeks to achieve and those whose consequences one seeks to avoid. Dividing the goals the investor seeks to achieve into “needs, wants, wishes, and dreams” provides the adviser with an initial sense of the urgency of each goal. A need typically must be met and so should command a 90%–99% probability of success, while at the other end of the spectrum, it is an unfortunate fact that we all live with unfulfilled dreams, whose required probabilities of success probably fall below 60%. A parallel—and analogous—structure can be created to deal with goals one seeks to avoid:26 “nightmares, fears, worries, and concerns,” with similar implications in terms of required probabilities of success. In short, while some discussion of probability level may well take place, it can be informed and guided by the use of commonly accepted everyday words that will ensure that the outcome is internally consistent. The adviser avoids the use of jargon, which many clients dislike, and yet is able to provide professional advice.27

The simplest way to bring this concept to life is to work with a basic case study. Imagine a family, the Smiths, with financial assets of US$25 million. (For the sake of simplicity, we are assuming that they do not pay taxes and that all assets are owned in a single structure.) The parents are in their mid-fifties, and the household spends about US$500,000 a year. They expect that inflation will average about 2% per year for the foreseeable future. They express four important goals and are concerned that they may not be able to meet all of them:

1. They need a 95% chance of being able to maintain their current expenditures over the next five years.

2. They want an 85% chance of being able to maintain their current expenditures over the ensuing 25 years, which they see as a reasonable estimate of their joint life expectancy.

3. They need a 90% chance of being able to transfer US$10 million to their children in 10 years.

4. They wish to have a 75% chance to be able to create a family foundation, which they wish to fund with US$10 million in 20 years.

EXAMPLE 9

Understanding Client Goals

1. A client describes a desire to have a reserve of €2 million for business opportunities that may develop when he retires in five years. What are the important features of this goal?

   Solution to 1:

   The time horizon is five years. Words such as “desire” in describing a goal, compared with expressions indicating “need,” indicate that there is room for “error” in the event that capital markets are not supportive. The portfolio required to meet the goal described as a desire will likely be able to involve a riskier profile. One would want to verify this assumption by comparing the size of that goal compared with the total financial assets available to the client.

2. A 70-year-old client discusses the need to be able to maintain her lifestyle for the balance of her life and wishes to leave US$3 million to be split among her three grandchildren at her death. What are the important features of this situation?

   Solution to 2:

   The key takeaway is that although the two goals have the same time horizon, the two portfolios designed to defease them will have potentially significantly different risk profiles. The time horizon is approximately 20 years. The first goal relates to maintaining the client’s lifestyle and must be defeased with an appropriately structured portfolio. The second goal, relating to the wish to leave some money to grandchildren, will allow more room for risk taking.