Starting at the End

When registered reps set about advising clients on where to put their money, they usually focus on risk tolerance. A conservative-minded client, for instance, might get a portfolio heavily laden with fixed-income products; a more aggressive client would get more equities.

The approach sounds reasonable enough and is widely accepted, but it's hardly the only way to meet a client's needs.

An alternative method — one that is gathering more attention all the time — is to start at the end, letting a client's goals determine what kind of portfolio he requires. In a goals-based approach, the overriding factor in choosing investments is how the proceeds from the investments will be used. The client's risk tolerance comes into play only when viewed through the lens of his goal for a particular investment.

One of the most attractive aspects of goals-based asset allocation is that it is easier for clients to understand and for advisors to explain. In addition, advisors typically find its principles easier to apply to clients' portfolios than modern portfolio theory alone.

Theory Into Practice

The first step in creating a goals-based portfolio, is to create a framework or “user interface” for modern portfolio analysis that individual investors will understand. Within that framework, a client's requirements can be organized as a set of goals.

Here are eight goals common to many clients:

Monthly expenses

For some people, their investments serve to provide them cash on a monthly basis to meet living expenses.

Unexpected expenses

Unanticipated expenses should be supported by a savings and investment account and not a credit card.

Emergency reserve

Financial planners often recommend holding three to six months worth of regular expenses in an emergency fund to cope with financial disasters.

Savings

People save for larger expenditures, such as travel, a new car or a down-payment on a home.

Retirement or financial independence

It is common to save for retirement using tax-deferred accounts, but some investors also save in taxable accounts toward the broader goal of becoming financially independent.

College savings

Rising tuition costs have caused parents to be more serious about saving for college. Educational IRAs and 529 plans offer tax deferment.

Gifting and estate planning

Giving to heirs is a common goal for individuals with larger portfolios.

Philanthropy

Some investors set aside money they can use to support charities and other worthwhile causes.

These goals, or uses for money, cover most of the needs of individual investors.

The next step is to bundle all the relevant goals together and then assess the risk tolerance of the client. In assessing risk, however, it is important to place the needs attached to each goal first. For instance, no matter how aggressive a client might be, his “emergency money” should probably be in a portfolio not subject to the vicissitudes of the markets. On the other hand, even a very conservative client might want to devote at least a portion of his long-term retirement money to more risky, high-return assets. Otherwise, significant growth will be hard to achieve.

Clearly, each client's goals are unique. One might have several children and require several college funds maturing on different dates — in addition to retirement savings and emergency money. Another might be childless and inclined to channel his money into charities later in life. Still, clients should have a use in mind for each segment of their portfolio — or at least an idea of how the money eventually will be spent. These goals often are only vaguely understood by investment managers who tend to think of the portfolio in terms of asset classes that need to be diversified, rather than in terms of concrete objectives that need to be achieved.

Risky Business

The term “risk tolerance” comes from the parameter in the mean-variance equation that compares average return with the variance of return. It is meant to describe the investor's marginal utility for accepting an extra amount of risk. In other words, how much extra return does an investor require to assume additional risk?

This concept is useful for combining asset classes, but attempting to assess an individual's marginal utility is not easy because the concept is highly theoretical. What is needed is a better interface between modern portfolio theory tools and behavioral finance — the way investors really think.

Jean Brunel, managing principal of Brunel Associates in Edina, Minn., suggests four key criteria for constructing portfolios that meet investors' goals:

Liquidity

Funds that the investors will need over a relatively short time.

Income

The cash flow needs anticipated by investors to maintain their lifestyles.

Capital preservation

The need for investors to avoid experiencing significant declines in the value of their capital.

Growth

The need to see capital appreciate.

These are by no means new concepts in the world of investing, but the way Brunel applies them, using the tenets of behavioral finance, is both new and powerful.

The key point is that modern portfolio theory is a great theory and tremendously helpful for understanding how to diversify a portfolio, but it does not accommodate the realities facing investors: time horizon, taxes, liquidity needs, income needs and goals for the future.

Also, traditional portfolio management is too limited in its view of an investor. Each person who invests is simultaneously seeking growth, trying to preserve capital, concerned about liquidity and might also require income. Attempting to label investors “conservative” or “aggressive” for all their funds — emergency as well as retirement — misses the complexity of that investor's needs and attitudes.

An added benefit of using a goals-based approach is that you assess your clients' investment needs through their eyes, not through yours. Your clients expect you to invest their money in ways that serve them best. Their individual goals-based portfolios should be diversified according to modern portfolio theory, but they should be understood by looking at their goals.

When you interview clients you will start to present their choices in a framework that is natural for them to understand. Few can doubt that is the best approach.

Writer's BIO: Paul Bouchey is a senior research analyst with Russell's Investment Group. He researches and builds quantitative decision models for Russell consultants and their clients.

Goals and Considerations