For years, many investors and advisors have measured success by whether they "beat the benchmarks." However, last year's market collapse revealed the stark pitfalls of benchmark investing. Many theoretically conservative portfolios and mutual funds lost upwards of 30%. In turn, many investors lost more money than they could afford.
To understand the roots of this problem, it's important to understand the traditional advisor/client relationship. In general, an advisor initially meets with a client and discusses the client's goals in order to determine cash flow needs and asks the client to complete a risk tolerance questionnaire. The advisor might prepare an investment policy statement with a recommended asset allocation according to the client's risk profile. The advisor then explains that she uses XYZ mutual funds because of their excellent performance against peers. The advisor develops a portfolio of funds in line with their asset allocation model for that client's risk tolerance.
The problem with this scenario is that the resulting portfolio is focused on investment returns, not the client's overall financial picture. If there is any blip in the chosen funds' returns, the advisor will likely respond by swapping it out for a better-performing peer. While well-intended, such a move won't ensure that a client can fund their child's college education or retire at age 65.
This is why goal-based investing is so important. In layman's terms, this simply means aligning assets with liabilities. For investors, assets include their salary, investments, real estate, Social Security payments, and so on. Liabilities include debts as well as a client's specific financial goals such as funding college tuition, retirement costs, or buying a vacation home.
The idea is to structure a client's portfolio so that they can fund all of their necessary goals (highest-priority), and then allow incremental risk to achieve more aspirational goals (lowest-priority).
In practice, a goal-based advisor discusses with a client their goals in order to understand how their current investments line up against their personal financial circumstances. The advisor explains that it doesn't matter if the client's investment portfolio beats the benchmark index. What matters is that they're able to put their kids through college. To crunch it all out, the advisor prepares a household balance sheet, cash flow plan and optimal investment recommendation for the client. To ensure a client can fund all of their necessary goals, she "dials down" the risk in their investment portfolio. She might use the same XYZ funds, but the focus is on how they perform against the client's goals--not their peers or the S&P 500.
Granted, there are clients who will ask about individual fund performance. This is an educational opportunity. A goal-based advisor would respond by saying something like, "XYZ is a sound investment company, and I have every confidence in their management ability. But let's review where you are against your goals, because that is what matters." The advisor doesn't swap out funds to show they're on top of things. The advisor understands the client's goals and where the client stands in relation to achieving these goals in order to genuinely be on top of things.
All this is intuitive for most advisors, and many advisors already take a goal-oriented approach. The crux is that there are limited tools available to provide such individualized and dynamic services in a way that's efficient, especially if the advisor has a large number of clients.
In these turbulent times, advisors need to spend more face time with clients and deliver better portfolio results in order to keep, let alone grow their practices. Goal-based investing--focusing wealth management on helping clients achieve their unique goals--is the first step toward this. And, it beats outperforming the benchmarks any day.
President and Chief Operating Officer