ISSUES RELATED TO GOALS-BASED ASSET ALLOCATION

https://study.cfainstitute.org/app/cfa-institute-program-level-iii-for-august-2024#read/study_task/2562333/issues-related-to-goals-based-asset-allocation-1

Learning Outcome

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

Once set, the goals-based allocation must be regularly reviewed. Two considerations dominate:

1. Goals with an initially fixed time horizon are not necessarily one year closer to maturity after a year. Superficially, one would expect that someone who says that his or her need is to meet lifestyle expenditures over the next five years, for instance, means exactly this. Accordingly, next year, the time horizon should shift down to four years. Yet experience suggests that certain horizons are “placeholders”: One year on, the time horizon remains five years. This is particularly—and understandably—relevant when the horizon reflects the anticipated death of an individual.

2. The preference for upward rather than downward volatility, combined with perceptions that goals may have higher required probabilities of success than is truly the case, leads to portfolios that typically outperform the discount rate used to compute the required initial capital. Thus, one would expect there to be some need for portfolio rebalancing when the assets allocated to certain goals appear excessive, at least in probability- and horizon-adjusted terms. This situation gives rise to important discussions with taxable clients because any form of portfolio rebalancing is inherently more complex and costly in a taxable environment than when taxes do not come into consideration.

Issues Related to Goals-Based Asset Allocation

Although goals-based asset allocation offers an elegant and mathematically sound way to deal with the circumstances of individuals, it is not a panacea. By definition, goals-based asset allocation applies best to individuals who have multiple goals, time horizons, and urgency levels. The classic example of the professional who is just starting to save for retirement and who has no other significant goal (as in the case of Aimée Goddard in Example 1) can be easily be handled with the traditional financial tools discussed in the earlier sections of this reading.34 However, one should always be cautious to ensure that there is no “hidden” goal that should be brought out and that the apparently “single” retirement goal is not in fact an aggregation of several elements with different levels of urgency, if not also different time horizons. Single-goal circumstances may still be helped by the goals-based asset allocation process when there are sustainability or behavioral questions. In that case, one can look at the single goal as being made up of several similar goals over successive time periods with different required probabilities of success. For instance, one might apply a higher sense of urgency—and thus require a lower risk profile—to contributions made in the first few years, on the ground that adverse market circumstances might negatively affect the willingness of the client to stay with the program. In many ways, this approach can be seen as a conceptual analog to the dollar-cost-averaging investment framework.

Goals-based asset allocation is ideally suited to situations involving multiple goals, time horizons, and urgency levels, whether the assets are large or more modest. In fact, in cases where “human capital” is considered, a multi-goal approach can help investors understand the various trade-offs they face. Ostensibly, the larger the assets, the more complex the nature of the investment problem, the more diverse the list of investment structures, and the more one should expect a client-focused approach to offer useful benefits. However, the ratio of cash outflows to assets under consideration is a more germane issue than the overall size of the asset pool.

Advisers using goals-based wealth management must contend with a considerably higher level of business management complexity. They will naturally expect to have a different policy for each client and potentially more than one policy per client. Thus, managing these portfolios day to day and satisfying the usual regulatory requirement that all clients be treated in an equivalent manner can appear to be a major quandary.

Typically, the solution would involve developing a systematic approach to decision making such that it remains practical for advisers to formulate truly individual policies that reflect their investment insights. Exhibit 40 offers a graphical overview of advisers’ activities, divided into those that involve “firm-wide” processes, defined as areas where no real customization is warranted, and those that must remain “client focused.” The result is analogous to a customized racing bicycle, whose parts are mass produced but then combined into a truly unique bike custom-designed for the individual racer.

Exhibit 40:

Goals-Based Wealth Management Advisory Overview