Wealth management today: 8 things you need to know about goal-based investing

Thought Leader - Wealth Management Investment Analytics, IBM

Wealth management services are designed to help investors meet their financial goals. Yet standard wealth management approaches focus on risks affecting the market as a whole, not on risks specific to individual investors and their assets.

Gaining a clear picture from goal-based investing

Goal-based investing is the new norm for private wealth management. Recognizing that investors’ goals are a more important target than expected return, goal-based investing provides significant advantages for investors and wealth management advisors. Investors gain a clear picture of their financial status relative to their future objectives, while firms gain an opportunity to differentiate themselves from the rise of robo-advisors with an effective, personalized service.

Goal-based investing combines insights into investor behavior with Probabilistic Scenario Optimization (PSO), a new methodology introduced in Modern Portfolio Management: From Markowitz to Probabilistic Scenario Optimisation. The book addresses the shortcomings of traditional portfolio theory. Here are eight things private investors, financial advisors and wealth management institutions should know about developing a competitive offering for the new standard in wealth management. 

1  Goal-based investing is an investor-centric approach

Through goal-based investing, client goals are identified, and progress toward these goals becomes the main benchmark for measuring the success of a private portfolio. Portfolios are rebalanced over time to reflect changing goals and client priorities. Individual goals replace traditional benchmarks, such as market indices and standard deviation, that may reflect current market conditions but do not reflect the ability to achieve client goals at a future point in time. Risk is measured in terms of the uncertainty or inability to meet each personalized goal.

Once client goals are identified, they can be used as the basis to find appropriate investment solutions. When investors can measure their progress toward specific goals, it reduces the likelihood of overreactions to short-term volatility of a specific asset or asset class. Goal-based investment engages clients by having them actively involved in the decision-making process about their holdings, without requiring them to have in-depth investment knowledge.

2  Goal-based investing takes into account investors’ time horizons

Imagine a client whose primary goal is to ensure a certain income is available at retirement. Over the course of a calendar year, the client’s portfolio posts a 20 percent return and outperforms the market by a significant margin. The client may feel very happy with the holdings, and gain confidence that they are on the right track. The client’s goal, however, is not to outperform markets, but to ensure a certain standard of living will be available upon retirement. If it turns out that the portfolio is dramatically underfunded at the time the funds are needed, the client could be in for a rude awakening. The real service that wealth management aims to provide is not to outperform current markets, but to ensure that a client’s goals are funded when that funding is needed.

The traditional approach to wealth management focuses almost exclusively on market risk. Clients are lumped into one of a few broad categories based on risk tolerance, financial knowledge and a small number of stated goals. Their assets are then added to a bucket or portfolio that best matches their investor profile.

Clients may experience short-term confidence or regret about their portfolio, but have no real ability to measure the ultimate success of their investment strategy. Goal-based investing helps wealth management advisors guide investments based on the unique needs and time horizons of each client, and provides a rationale to look beyond short-term market volatility.

3  A rift exists between what traditional wealth management services promise and what they deliver

Since the financial crisis in 2008, many investors have become concerned that they have not been receiving good advice about managing their assets, and they can no longer count on their investments to deliver expected returns. The trust of higher net worth clients was particularly affected, as investment strategies, supposedly tailored to their specific circumstances, failed to protect them from severe volatility. Jean L.P. Brunel, chief investment officer at Florida-based GenSpring Family Offices, noted that absolute return strategies, “which were never supposed to post a negative return, posted –20 percent returns. Investors were living through a six-standard-deviation event, and many of our clients were now asking for something different.”

Clients felt their assets were being attacked from two sides—by investments that were underperforming relative to expected returns and the fees being paid for advisory services. In response, many investors have been gravitating toward robo-advisors, where they can gain investment strategies, portfolio analysis and automatic rebalancing at a fraction of the cost.

The problem is that the underlying strategies used by robo-advisors are the same ones that disappointed investors during the financial crisis. Robo-advisors offer algorithm-based advice that relies on broad diversification and extended investment terms. Risk is defined in market-based terms, and is disassociated from the investor’s personal goals. Unless the underlying methodology for portfolio management is changed, neither group will be able to communicate with investors on a personal level, or provide a goal-based approach to investment.

4  Modern portfolio theory is not equipped to handle today’s market complexity

Traditional investment strategies utilized by wealth management and robo-advisors descend from Modern Portfolio Theory (MPT), proposed by Harry Markowitz in his classic 1952 paper, “Portfolio Selection.” Markowitz advocated a diversification strategy that focused on the overall risk-reward profile of portfolios, not individual securities. Markowitz envisioned that investors would make informed, rational decisions about their portfolios, and that market returns and volatilities would operate within normal statistical assumptions.

Markets events of the 21st century have emphasized the shortcomings of this hypothesis. The dot-com crash and the financial crisis confirmed that markets can often operate outside of normal statistical assumptions. Investors, far from acting rationally, often make decisions based on little or no information. Markets and investors cannot be expected to behave within standard assumptions. Instead, adapting investing strategies and methodologies to the realities of market performance and investor behavior would seem more logical.

Because of its limitations in defining risk, MPT is not a suitable approach for goal-based investing. PSO is better able to take into account the realities of complex products, market behavior and investor decision making.

5.  PSO removes the limitations of MPT

PSO is a renewed interpretation of MPT, based upon a risk-management perspective. Through PSO, the probability of achieving a desired target return, or income stream, bounded to a maximum risk limit is chosen as the statistical measure that enforces optimal portfolio allocation. This measure is achieved by explicitly stating investment goals and downside boundaries.

Expected return is replaced with the investor’s individual goals, while standard deviation is replaced with the likelihood of missing the goals. In this way, PSO allows for a richer representation of an investor’s ambitions across a multiple-period timeframe.

MPT considered portfolios made up of individual securities that were relatively easy to price. Today, structured products with complex payoffs are more challenging to value, and harder to optimize through standard deviation. Yet these mathematically complex products are commonly traded and often make their way into investor portfolios. PSO is a framework that can simulate these complex products during the portfolio optimization process, and simulate investments over time in a transparent fashion. Comparing the outcome of these simulations against the goals and constraints of individual investors provides more useful benchmarks for investors than past performance or relative short-term returns.

PSO supports additional measures to determine the successful optimization of a portfolio. These factors include: progress toward the investor’s goals, how well the investor’s portfolio interacts over time with the risk factors impacting the present value of the investor’s goals and the present value of non-tradable assets and future income streams. PSO is therefore an ideal framework for goal-based investing, given the importance of reaching tangible future goals and the mathematical complexity of financial products commonly traded in today’s markets.

6  PSO and goal-based investing can prioritize different, even contradictory,  goals

Investors often have multiple and, sometimes, conflicting goals. For each goal that a client may have, an individual asset pool with an individual asset strategy is created. This situation refocuses the investment advisor’s initial work away from product picking toward portfolio management and rebalancing.

As a simplified example, imagine a client with two principal ambitions: saving for long-term retirement income and to purchase a summer home. The investment manager can prioritize these goals and assign a sub-portfolio and appropriate investment strategy for each. Knowing the importance of maintaining the client’s lifestyle, the retirement portfolio strategy may lean toward fixed income products, particularly as the client gets closer to retirement. The goal of a summer home may be more aspirational and dependent on discretionary funds. The amount of money on hand and the amount needed to purchase the home would help determine the asset allocation and risk profile of that sub-portfolio. The portfolio as a whole is also evaluated to ensure that the overall risk profile is in line with the investor’s profile.

After seeing their goals and related investment strategies laid out, clients may decide that they want to reprioritize certain goals or risks. PSO enables wealth managers to review risk and reward profiles with clients in the context of personal goals, while the goal-based investing method provides clients with the opportunity to discuss these choices in language they can understand.

7  Narratives are more important to investors than algorithms

When people are asked to make decisions with limited information, they often seek and construct reasons to help them decide. In a well-known study of reason-based choice, psychologists asked subjects to imagine they were jurors tasked with awarding sole custody to one parent following a messy divorce. The subjects were told that the case was complicated, but they must make a decision based only on the information available.

Parent A was described as average in each listed category: income, health, working hours, rapport with child, stable social life. Parent B was described in greater detail, featuring both positive traits—above average income, extremely active social life, very close relationship with child—and negative ones—heavy travel because of work and minor health problems. A majority of subjects chose to award custody to parent B. A majority of subjects in a second group that was asked to deny custody to one of the parents, also chose parent B.

The authors of the paper concluded that, when faced with a choice that is hard to resolve, “people often search for a compelling rationale for choosing one alternative over another.” In terms of investments, an investor’s personal life presents this compelling reason. Concepts of market performance and regression toward the mean can be vague and easily misunderstood. College tuitions, retirement funds and travel are easier concepts for investors to understand and prioritize. Incorporating a narrative function into the investment process also minimizes the likelihood of “irrational investment behavior” which may include overconfidence, regret aversion, herding and an unwillingness to admit mistakes.

8  Goal-based investing provides a value-added service to wealth management clients

In a recent article for The New York Times, economist Sendhil Mullainathan confessed the anxiety he felt when checking his retirement account for the first time in years. Mullainathan had to search for missing passwords; was confused by why so much of his money was in cash, earning next to nothing; and wondered why he chose some particular funds over others. He wrote that with investments, unlike other markets, we may not know for decades if a good decision was made. And by that time, it’s too late. As a result, people may well choose to focus on decisions they can evaluate right away, even if they are far less important than financial security.

Mullainathan’s confession is likely representative of a large group of financially literate investors who are disengaged from the investment process. Others may have lost trust in their advisors and the wealth management process in general following the financial crisis. These groups, as well as the growing number of high net-worth clients that have complex and often competing goals for their future, represent an opportunity for banks and wealth management advisors, who can differentiate themselves with a new level of personalized service through goal-based investing.

Giving clients the personal touch

By connecting with clients on a personal level that can be discussed with everyday language, goal-based investing provides a legitimate value-added service. It represents a compelling alternative to robo-advisors, which may offer low fees but continue to base portfolio optimization on outdated investment concepts.

Using PSO as an optimization strategy enables advisors to combine the added-value asymmetry of real products with the lifecycle requirements of investors. Investors acquire an intuitive, graphical representation of their portfolios supporting better comprehension and improved confidence, while also satisfying regulatory requirements for transparent, risk-based communication. Most importantly, goal-based investing engages clients and can engender loyalty by making their goals the priority of investment strategies and portfolio construction, which is where they arguably should have been all the time.

Learn more about goal-based investing, and how IBM Analytics enable wealth managers to personalize asset allocation—better reflecting clients’ ambitions, concerns and investment horizons, and deepening customer engagement for growth.