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.”
That investors’ objectives — be they college funding, retirement or the purchase of a home — all have specific dollar objectives and time frames may argue for LDI. But acknowledging that not all goals are clearly known ahead of time, the UBS exec argues for “an intuitive, logical, integrated goals-based framework” that incorporates MPT investing insights as well.
The result is UBS’s advocacy of a three-bucket approach matching three easy-to-remember “L” words: liquidity, longevity and legacy.
As their names suggest, the first bucket includes cash or cash-like instruments that can meet expenses planned over the coming 2-5 years; the second bucket is a balanced or growth portfolio “sized to match future goals and objectives through the 95th percentile of the household’s life expectancy; the third, legacy bucket meant for heirs or charitable donations has a long timeframe and, as such, is invested for growth.
So if a wealthy UBS household requires $400,000 in spending a year for the coming three years, Crook uses a simple net present value calculation to determine that the family would need $1.19 million at an annual return of 2% in that first bucket to meet that need.
The relative sizing of buckets would depend on where a household was within the investing life cycle. An investor in his 20s, 30s or 40s would typically be funding immediate spending needs out of current income and would therefore hold relatively little in their liquidity bucket.
Their focus would be on preparing for longevity (bucket No. 2) through saving and investing in growth while hedging for risk through disability and life insurance; their legacy bucket would also likely remain largely empty at this time.
The buckets take on different dimensions as retirement approaches, at which time some of the contents of the middle longevity bucket, now full, is poured into the liquidity and legacy buckets. Filling the former has a “natural de-risking effect,” and the addition of annuity or LTC products to the longevity bucket also curbs risk.
Another interesting effect of using this model:
“Investors that have large legacy portfolios relative to their spending will actually find that their average portfolio risk increases during retirement, as that bucket comprises a growing portion of their overall assets. Although this might seem to conflict with conventional wisdom, it is the correct result based on lifecycle investing theory,” Crook writes.
While that third, legacy bucket would provide the most ample space for Harry Markowitz-style portfolio-optimization investing, a theme of the UBS paper is that a bucketing approach can help investors take a broader view and minimize behavioral errors that are more apt to occur when the focus is on underperforming a benchmark.
As UBS strategist Matt Baredes puts it in an article on the behavioral advantages of bucketing later in the issue:
“Goals-based investing enables investors to measure themselves relative to their goals … rather than focusing on … beating a particular market index. Given that goals can be modified, this allows investors … to focus on what is actually important to them (achieving their goals) as opposed to a relative performance number.”
— Check out Finding Your Client’s Place on the Efficient Frontier on ThinkAdvisor.