Even the most exemplary investment in theory, with high expected returns, doesn’t cut it if your goal is to pay a bill due next month.
Of course this is just common sense, and financial advisors in particular are aware of the difference between short-term funding needs and long-term portfolio optimization.
Still, there may be an inherent conflict between the assumptions of modern portfolio theory (MPT), which seeks to provide the highest return per level of risk, thus generating an optimal portfolio along each investor’s efficient frontier, and … life, where disparate goals and risk levels coexist simultaneously.
That complex reality is the basis of what is known as life-cycle investing theory, an alternative to MPT espoused by Paul Samuelson, Robert Merton and Zvi Bodie among others.
That approach, variously known as liability-driven or goals-based investing or, at the retail level, the bucket approach, has long been favored by pension funds that need to match investment assets with specific funding dates.
Perhaps more surprisingly, it is also embraced by UBS Wealth Management, at least in the executive suites where the firm’s investment strategists and financial planning researchers reside.
It is that research team that devoted its latest edition of Your Wealth & Life, the firm’s quarterly communique to wealth management clients, to the topic of goals-based investing.
The paean to three-bucket investing includes a broad explanation of the concept, case studies and an interview with behavioral finance expert and University of Chicago professor Richard Thaler, all in support of a process meant to improve investor outcomes and prevent poor trading decisions.
The publication’s editor, Michael Crook, who heads the firm’s portfolio and planning research, offers the primary framework for understanding goals-based investing’s contribution to wealth management.
MPT, he says, has offered critical insights that benefit investors—such as the need to take all assets into account in making investment decisions or the risk-minimizing benefits of diversification.
But he cites studies showing that alternative approaches to investing can perform as well as MPT’s portfolio optimization, and offers liability-driven investing (LDI) as a counterexample to MPT’s focus on volatility as the key measure of risk. According to LDI, the key risk is not being able to make a required payment at the time it is needed.
That is why pension analysts are apt to evaluate a plan’s efficacy on the plan’s funded ratio — the probability that its assets will be sufficient to pay plan beneficiaries.
Crook illustrates the real-world difference between the approaches thusly:
“No matter the ‘risk tolerance’ of the individual, investing funds earmarked for a grandchild’s college tuition in a moderate portfolio makes very little sense if the check is due at the bursar’s office in six months, but might be perfectly rational if college is still seven years away.”