When we invest, we make an important choice not to spend money today so that we can live better in the future. This means we have a goal or a reason to invest in the first place. Otherwise, what's the use of investing?
Why not start from that goal when we build an investment strategy? Individual investors are not institutions. We have a limited time horizon, we pay taxes, we sometimes react emotionally to swings in the market. Building portfolios for individuals should be different.
Standard practice is to assess an individual's total risk tolerance and recommend an investment allocation that's roughly in line with the client's appetite for risk. Goal-based investing goes a step further. What is the purpose of these investments? How much is the future spending goal, and how much risk is the investor willing to take that they will fail to meet this goal?
A new stream of literature in finance asks the question: What does it actually mean to develop portfolio strategies that focus primarily on the goal that motivates the investment today? After all, people don't just invest to build wealth. They set money aside today for a future purpose. Maybe it's to fund spending in retirement or to pass on a legacy. But investing is a means to an end, and the end is what's really important.
The Spending Goal
Goal-based investing assumes that the spending goal should drive the investment strategy. An investor can be relatively risk tolerant, but if their spending goal is not flexible (for example, medical spending or living expenses in retirement) then the investment portfolio should reflect the inflexibility of the future goal. And the investments selected today to meet that future goal should be those that offer the highest expected after-tax payout for the amount of spending flexibility an investor is willing to accept.
In a 2012 article in the Journal of Financial Planning, Duncan Williams of the University of Georgia, Wade Pfau of The American College and I argued that spending flexibility is how we should define risk tolerance when matching a portfolio allocation to a future spending goal. If we can be more flexible with our spending goal, then we can take on more investment risk.
How do we manage a risky portfolio over time in order to meet a future goal? Goals are tricky because they are often fixed, say, $2 million for retirement, but they must be funded with investments with unknown future returns. High investment returns mean the goal is more easily funded. Low returns mean that an investment plan can be derailed.
What does it mean when asset returns don't measure up to expectations? From the perspective of a goal-based planning philosophy, it means that the investor may fail to meet their goal — unless they take some sort of corrective action.
In a 2011 study published in the Journal of Wealth Management, Anil Suri, managing director and head of portfolio analytics for Merrill Lynch, detailed a goal-based investing process that helps investors understand how they are making progress toward their goal and then gives them the tools they need to make the right corrections along the way.
“Instead of thinking of what's going on in the markets,” said Suri, “think about whether you’re on track and making progress to achieving your specific financial goals.”
This means working with a client to set realistic goals with a defined time horizon and an acceptable level of risk. What does risk mean in a goal-based planning framework? Through the magic of statistics, it's possible to establish a minimum acceptable probability of meeting a goal.
If the goal is not flexible, then a client may establish a 90% or 95% probability of meeting the goal. For a more aspirational goal, it may be acceptable to set a 60% probability. (Remember that if you’re plugging in historical averages to estimate future returns, you’re starting with a 50% probability of success.)
Risk & Returns
This is where statistics comes in handy. The average historical geometric return on a 10-year investment in a balanced U.S. stock/bond portfolio is 7.4%. The client can fully immunize the goal today by investing in a zero-coupon Treasury bond paying 3% that will mature at the goal date. But most investors will be better off accepting a certain amount of investment risk. This means that returns could be lower than the bond, but more than likely will be higher — especially over a long-run time horizon (more on this later).
It makes sense to assume a portfolio return that is higher than today's 3% 30-year zero-coupon Treasury rate. How much higher is determined by the composition of the portfolio and how flexible you are willing to be with the goal.
Historically, the 20th percentile of balanced portfolio returns is 4.8% in the U.S. The cost of funding a $2 million goal with Treasuries will be $42,039 per year. Assume a 4.8% return on a balanced portfolio with an 80% probability of success, and the client can save $31,152 a year, or more than 25% less.
I find this approach attractive for a number of reasons. First, it helps the client understand the tradeoff of not taking investment risk. If you don't take risk, you’ll have to invest more today to meet your future goal. But if you do take risk, there is a chance that you won't meet your goal. That's what investment risk is all about. This helps a client understand how risk affects financial goals.
Second, it helps a client understand tradeoffs when they get unlucky. If your portfolio falls by 10% over the year, you need to accept the reality that the probability of reaching the $2 million goal by saving $31,152 a year has decreased below 80%.
The good news is that you can use statistics to estimate how much more you need to save each year to maintain the same probability of success. If the increased savings rate isn't going to fit within a client's budget, then they either need to face the choice of accepting a reduced probability of success (say 75%) or a new goal target (say $1.8 million).
Suri likens the annual portfolio evaluation to traveling with Google Maps. When you’re driving toward your destination, Google will provide the best directions at the time you leave. However, traffic may change along the way and the app will recommend a course correction.
Let's also talk about some advisor myths that need to be busted. If you’re assuming a historical portfolio return when projecting how much a client needs to save to meet a goal, then you are building in (at least) a 50% chance that the client will fail to meet this future goal amount with the savings plan. This is what a normal distribution means.
Half of the observations will rise above the central tendency and half will fall below. And most economists are projecting 21st century asset returns that are significantly less than 20th century asset returns, so using 20th century return projections will likely result in a failure rate higher than 50%. Sad!
What about the myth that if asset returns disappoint over the first few years, a client can simply continue saving the same amount if they can have patience and wait for markets to recover? This advice makes me feel good and is valuable to clients who want to panic after a bear market, but it isn't statistically accurate.
If a client gets unlucky and returns fall below projections, then the probability of meeting their long-run goal has changed. They either need to save more, reduce their required probability of success or reduce the size of their goal.
The client whose portfolio lags behind return expectations can choose to take more risk in order to meet their long-term goal with the same savings rate. But taking more risk means an increased probability that the client will get nowhere near their goal. Doubling down in Vegas is one way to break even, but it's not a great strategy for retirement.
According to Suri, “If you’re underfunded relative to your goal, then you have two choices. You can improve your situation by taking risk or you can lock in your underfunding. It's up to you to decide whether to take more risk or contribute a higher amount. There is no magic bullet that will kill the underfunding.”
As clients moves toward their goal, 80% of the time they will either be on track to meet their goal or be overfunded if they have received higher than expected returns. Suri believes that this is the time for advisors to begin discussing the possibility of de-risking an investment portfolio by locking in the goal amount with bond-like assets.
If you’re winning a race, it makes sense to be extra careful as you get closer to the finish line. The same is true with financial goals. “As you get closer to when you need the money, your risk aversion tends to go up” explained Suri. “That's rational in my view because the time horizon is shrinking.”
Portfolios in Practice
In a traditional mean-variance modern portfolio theory framework, investment selection is pretty straightforward. Assess a client's risk tolerance and build a well-diversified portfolio. Fill tax-sheltered accounts first, then save in taxable. Rebalance.
Goal-based investing is more siloed, but potentially more effective. The investment objective is to achieve the highest expected net (after-tax) annual return on an investment for a given level of risk in meeting a client's long-term goal.
How does one achieve the highest expected return? Make sure that the portfolio risk matches the time horizon of the goal. And make sure that the tax sheltering strategy is optimal for the time horizon and for the current and future tax environment of the client.
Although it isn't that controversial among advisors, matching asset allocation to a client's time horizon is quite a controversial topic among academics. Theoretically, stocks shouldn't become less risky the longer you hold them.
Risk means that the distribution of outcomes should increase over time. If stocks have a higher average return than bonds, then a stock investor will usually beat a bond investor, but this will be offset by some really dramatic long-term losers.
In truth, there haven't been that many time periods where stocks were losers when held for a long period of time — and not just in the United States. David Blanchett of Morningstar, Pfau and I found that this so-called “time diversification” effect occurred in 18 out of 20 countries. The only country where equities really had a rough time relative to bonds over longtime horizons was Switzerland. We estimate that investors would be significantly better off if they increase their portfolio risk for long-run goals.
Why does this matter in goal-based investing? Because a long-term investor could assume a higher expected portfolio return from investing in stocks at the same level of acceptable risk.
In other words, they could reach the same $2 million goal by saving less each year if they’re willing to accept greater investment risk. This sounds like a pretty sweet deal. The investor can meet their goal and the advisor adds value by helping them maintain a healthy allocation to stocks over time.
Assets & Advice
Scott Cederburg, an assistant professor at the University of Arizona, recently co-authored a paper soon to be published in the Review of Financial Studies that discusses whether investors can rely on stocks being less risky in the long run. According to Cederburg, “We don't have many observations of what can happen over 20-30-year time periods.”
Since we don't fully understand what drives the observed time-diversification effect, this means that “risk-averse investors would optimally invest somewhat less in stocks once they take the additional uncertainty into account, which would help to guard against the possibility of an extended downturn in stocks,” he says.
How would Cederburg counsel advisors who are developing portfolio strategies for long-term investors? “I would tend to advise younger clients to invest somewhat more in stocks compared to shorter-horizon investors,” he explained, “but the answers are not quite as obvious as the conventional wisdom may suggest.”
Thus, the practice of recommending riskier portfolios for long-term goals is reasonably solid, but certainly not settled science. On the other hand, the benefits of basic portfolio strategies on tax efficiency are considerably more reliable and the nuances are often underappreciated.
What does it mean to build an optimal asset location strategy? A spending goal is in after-tax dollars. And $2 million in a 401(k) is not the same as $2 million in money that can be spent on a retirement lifestyle. If all goals are after tax, optimal asset location means finding the account that provides the highest after-tax return given the time horizon of the goal and the estimated tax rates today and in the future.
This isn't easy, and we’ll save the details for a future column. Suffice it to say that time horizon and tax rates over time affect the performance of investments held within tax-deferred or tax-exempt accounts, and an advisor can add significant net portfolio performance by understanding the mechanics of asset location.
Since goal-based investing is more complicated, why do it? Why not just recommend a mix of funds and focus on then managing growth over time? Because that's probably not what most clients are looking for. They’re not just investing to grow assets, they’re investing for a purpose. Not only is the advisor making better recommendations, they’re also helping their clients understand why they’re saving and what it means to take risk.