Goals-Based Portfolio Theory

By Franklin J. Parker

An in-depth overview of investing in the real world

In Goals-Based Portfolio Theory, award-winning Chartered Financial Analyst® Franklin J. Parker delivers an insightful and eye-opening discussion of how real people can navigate the financial jungle and achieve their financial goals. The book accepts the reality that the typical investor has specific funding requirements within specified periods of time and a limited amount of wealth to dedicate to those objectives. It then works within those limits to show you how to build an investment portfolio that maximizes the possibility you’ll achieve your goals, as well as how to manage the tradeoffs between your goals.

In the book, you’ll find:

• Strategies for incorporating taxation and rebalancing into a goals-based portfolio
• A discussion of the major non-financial risks faced by people engaged in private wealth management
• An incisive prediction of what the future of wealth management and investment management may look like

An indispensable exploration of investing as it actually works in the real world for real people, Goals-Based Portfolio Theory belongs in the library of all investors and their advisors who want to maximize the chances of meeting financial goals.

• Language: English
• Publisher: Wiley
• Release date: Nov 29, 2022
• ISBN: 9781119906124

Book preview

Goals‐Based Portfolio Theory

Franklin J. Parker, CFA

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Copyright © 2023 by Franklin J. Parker. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging‐in‐Publication Data:

Names: Parker, Franklin J., author.

Title: Goals‐based portfolio theory / Franklin J. Parker, CFA.

Description: Hoboken, New Jersey : Wiley, [2023] | Includes bibliographical references and index.

Identifiers: LCCN 2022017468 (print) | LCCN 2022017469 (ebook) | ISBN 9781119906100 (cloth) | ISBN 9781119906117 (adobe pdf) | ISBN 9781119906124 (epub)

Subjects: LCSH: Portfolio management.

Classification: LCC HG4529.5 .P365 2023 (print) | LCC HG4529.5 (ebook) | DDC 332.6–dc23/eng/20220803

LC record available at https://lccn.loc.gov/2022017468

LC ebook record available at https://lccn.loc.gov/2022017469

Cover Design: Wiley

Cover Image: © NDogan/Shutterstock

To my clients, especially the early ones,

who trusted me to figure it out.

And to the ones I love,

who often pay the price for my intellectual obsessions.

Foreword

by Jean LP Brunel, CFA

The Private Bank is a distribution channel! How many times have professionals who attempted to serve the specific needs of individuals heard that comment, way back when? Wait, was it really so long ago? The evolution in the nature of private wealth and of asset management (in the US in particular) inevitably led to the epiphany: Individuals are different, and they need different services.

Yet, if one goes sufficiently far back, private wealth was often inherited and structured around various trusts. That wealth had been accustomed to receiving services that were not necessarily quite different from those provided to institutions, except for the associated fiduciary services trusts required. After all, while the amounts may have been less substantial (although that was surely not always the case), it was felt that family trusts were very much like pension funds: long‐term horizon and in need of the higher returns associated with a substantial exposure to equities. Further, trust beneficiaries had been used to seeing equity market fluctuations and had seen that down legs were followed by up legs. The final element had to do with delegation: trust beneficiaries had no difficulty delegating the management duties; in reality, they were not even delegating them, as those duties belonged to trustees. Beneficiaries expected to be briefed on portfolio performance but had very limited, if any, expectations of being able to influence portfolio decisions.

Eventually, the long bull market that started in 1982 and the wave of mergers and acquisitions that began in 1981 brought an important change to private wealth. New wealth appeared: the old inherited wealth that had dominated was increasingly joined by new wealth, which had been more recently made or at least monetized.

New wealth had a different perspective of financial markets. The financial sophistication of individuals related to running companies, in other words, managing an income statement subject to balance sheet constraints; not of managing a balance sheet subject to income constraints. Their experience with financial markets frequently was limited. They did not always distinguish between a company and a stock, failing to appreciate the crucial issue of whether they were price makers or price takers. Finally, generational and potentially philanthropic structures that would work for them and their families had to be built: there were choices to be made and priorities to be assessed. There was the total novelty of how to bring the next generation into the wealth: From shirtsleeves to shirtsleeves in three generations ring a bell to anyone? They needed a variety of advisors, no longer relying on the formerly ubiquitous private banker, investment manager, and trust and estate lawyer.

It may have taken a while, but a response from the wealth management industry was bound to come. And it did, based on the work of people like Daniel Kahneman, Richard Thaler, Terrence Odean, Hersh Shefrin, and Meir Statman, to name but a few. These introduced the notion that individuals come with a number of biases and preferences that cannot be ignored. They provided the basis on which one could build. The classical belief that an investment policy must be the basis for the management of assets morphed into the appreciation that the sustainability of the policy is critical: The investor's worst enemy is the changing horses in the middle of the race syndrome. Behavioral finance effectively indirectly promoted the idea that policy sustainability would be greatly helped if one could create a link between my wealth and my goals. It led to the recognition that I do not have a single risk profile; I may well have a risk profile for each goal, noting that each goal may also have its own time horizon.

Early in the 2000s, a few individuals independently came to the view that identifying individual goals and specifying the portion of the wealth that should be dedicated to each was important.¹ The approach was originally named goals‐based wealth management. Unfortunately, the s of goals was briefly dropped, leading to the quip: Is not goal‐based wealth management very much like oxygen‐based breathing?

Four pioneers continued in their efforts and managed to convert a few people, but it took the seminal papers by Sanjiv Das, Harry Markowitz, Jonathan Scheid, and Meir Statman to truly open the path to the new discipline taking hold.² In fact, prior to the publication of these two papers, the published literature made an uneven use of fancy mathematics rather focusing their rationale on behavioral concepts. Their first paper, though, broke that mold using sophisticated mathematics to demonstrate with elegance that the so‐called bucket approach was virtually equivalent to the classical efficient frontier process, provided one made a couple of minor changes: the main change was the redefinition of risk away from the volatility of returns to the required probability of success in achieving a goal.

This book follows on the most recent tradition offering quite a bit of quantitatively driven analysis and demonstration. In many ways, it is a welcome return to the basics of the challenge: How do we help individuals achieve their goals in a way such that they will minimize the risk of changing horses in the middle of the race? At the same time, Franklin substantially broadens the analysis relative to what predecessors did. In that, the book is a must read, a must have. Rather than simply focusing on the question of formulating an investment policy, its purpose is to craft an entire theory around the concept of goals‐based wealth management. Thus, the author moves from the fundamental framework of strategic asset allocation to a review of all the kinds of decisions that individuals should make as they embark on the journey and remain on it.

Time allocation, portfolio rebalancing, tax efficiency, thematic investing, and goals‐based reporting are but a few of the issues the book tackles with brio. The crucial point, to this reader, is that there is no discontinuity or incongruity between adopting a sharp focus on goals and staying pure in relation to most traditional finance concepts. In fact, Chapter 13 gets to that point, presenting goals‐based portfolio theory as a bridge between traditional and behavioral finance, the former being normative while the latter is descriptive.

Does this mean that we have reached the end of the road? The answer, in my opinion, is not a simple no but an emphatic no. Goals‐based wealth management opened the conceptual way to accept the reality that individuals can have multiple, and at times even superficially contradictory, goals. It proceeded naturally from the realization that wealth management was about a lot more than asset management. It all started with the notion that there were four stakeholders in my wealth and that individuals or advisors were particularly interested in three of them getting as much as they could while the fourth should be getting as little as possible. These four stakeholders were basic needs: the individual's personal needs, his or her family's and potential future dynasty's needs, his or her philanthropic needs or, eventually, those of his or her heirs and the needs to pay to the government taxes on income and transactions carried out in the taxable portions of the overall portfolio.

There is still quite a lot of potential work for those who want to extend Franklin Parker's portfolio theory to include the multiple asset location issues that can crop up. An example of such a strategy, which was timely at one point and may no longer be, were charitable lead trusts in a very‐low‐interest rate environment. They could facilitate efficient inter‐generational transfers and accomplish charitable purposes as well. Their combined goals raised interesting investment and fiduciary issues, particularly as the assets had not terminally exited the family's ownership; only the part that went to charity had.

There are many other examples that one could point to, though the newest category seems to me to relate to the role of insurance products. Historically, investors have tended to eschew insurance, or at least eschew it as a part of a truly holistic wealth strategy. A common concern was that insurance comes with a cost. Some of that cost appeared to make sense, another part appeared too expensive, and individuals elected to self‐insure. Yet, a broader evaluation of the issue may help see an intriguing analogy to the thought processes that at one point led advisors away from considering a single overall portfolio solution. Insurance companies must be paid for the risk they take; on the one hand, however, from their points of view, that risk is diversified across a large number of insured clients. On the other hand, from the point of view of each client, the outcome is often purely binary: I die, or I do not die; I live out my life expectancy or I do not, and many variants on the theme. Thus, the cost of purchasing the insurance (which should be determined here from the point of view of the solitary insured) is and should be dramatically different from the cost of selling insurance (which should be determined from the point of view of covering a diversified pool of insured). Is there not a potential arbitrage there?

Historically, insurance had been perceived primarily as a tool to manage potential future estate taxes. It was always seen as relevant in that context, although the increase in the taxation threshold had made the solution appealing only to a very small minority. Now, consider the goal of preserving the ability to live out my life without changing lifestyle as a goal. Any solution that rejects any form of annuity is effectively based on the assumption that I am taking on my own longevity risk. Indeed, what happens if I exceed the life expectancy I had assumed? Combine this with a potentially cyclically nasty investment environment within some years of the life expectancy assumption, and the situation could become quite stressful. Franklin's book lays down a few markers on this issue and, doing this, I believe it is the first to take the issue into consideration.

I am delighted to have had the opportunity to write this Foreword, as I feel quite confident that Franklin will be among those who take the idea to which I modestly contributed and carry it much further forward. I would not be surprised if another book by Franklin were to surface in 5 or 10 years with further expansion of this theory. The need to serve individuals is not going away. A couple of future directions might help plant one or two seeds. What about the visible differentiation that exists between domestic money (assets that are managed on behalf of an individual who resides in a country and trusts that country's government to do the right thing) and global money (assets that are managed on behalf of individuals who want to keep some nest egg outside of their home country in order to ensure, in the words of a Filipino friend of mine 40 years ago, that I or my children will never have to wash lavatories in San Francisco)? Experience suggests that these two types of investors have radically different views of the risk of equities and of the risk of foreign currencies. What about the needs of families who incorporate an increasingly multinational, multicultural, multireligious population? The various discrepancies in the tax regimes—and in the tax principles—of several of the main countries today is enough to drive anyone to argue: Don't worry. But is that really the answer?

I certainly hope that you will enjoy the book as much as I did. It sets a new standard for our industry, one on which I hope Franklin and others will continue to build.

Notes

1 Jean L. P. Brunel, How Sub‐Optimal—If at All—Is Goal‐Based Allocation? The Journal of Wealth Management (Fall 2006): 19–34; Jean L. P. Brunel, Revisiting the Asset Allocation Challenge through a Behavioral Finance Lens, The Journal of Wealth Management (Fall 2003): 10–20; Ashvin B. Chhabra, Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individuals, The Journal of Wealth Management (Spring 2005): 8–34; Ashvin B. Chhabra, Clarifications on ‘Beyond Markowitz,' The Journal of Wealth Management (Summer 2007): 54–59; Dan Nevins, Goal‐Based Investing: Integrating Traditional and Behavioral Finance, The Journal of Wealth Management (Spring 2004): 8–23; Michael M. Pompian and John B. Longo, A New Paradigm for Practical Application of Behavioral Finance, The Journal of Wealth Management (Fall 2004): 9–15.

2 D. Sanjiv, H. Markowitz, J. Scheid, and M. Statman, Portfolio Optimization with Mental Accounts, The Journal of Financial and Quantitative Analysis 45, no. 2 (April 2010): 311–334; D. Sanjiv, H. Markowitz, J. Scheid, and M. Statman, Portfolios for Investors Who Want to Reach Their Goals While Staying on the Mean‐Variance Efficient Frontier, The Journal of Wealth Management (Fall 2011): 25–31.

Preface

Goals‐Based Investors and the Need for Better Theory

We all have goals. Sometimes those goals are financial.

Of course, many of our goals have little or nothing at all to do with finances, like respect from peers, raising children, being good people, or having a sense of purpose and accomplishment. Often, those goals are more important to us than our financial goals. They certainly occupy a larger percentage of our psychological capacity, day‐to‐day. Sometimes, we have goals we would like to achieve at some future date that could actually be accomplished using resources laid aside today. For those goals, some interaction with the ecosystem of financial institutions, markets, regulations, taxes, and people is warranted. When real people with real goals interact with this financial ecosystem, it is important that they have a reasonably effective map lest they find themselves wandering through the jungle that finance can so often be. This book is about using that ecosystem to accomplish financial goals—it is a better map (hopefully!).

But, to really understand how and why goals‐based investing is different, we must first understand goals‐based investors—that is, those real people who have real things they want to achieve in their very real lives. People do not enter this jungle for the fun of it, at least not usually. People enter this jungle hoping to come out the other side better off—to improve their lives and secure their future.

And it is here that traditional financial and economic theory has failed to provide even a reasonable map. I recently peer‐reviewed a scholarly paper whose lead author was an academic I greatly respect. The paper claimed to be operating in a goals‐based paradigm; that is to say, it was analyzing techniques that could be potentially used by goals‐based investors. Yet, despite the claim, the paper carried the very common academic assumption that an investor could use unlimited and costless short‐selling and leverage in an investment portfolio! I know of no real person who can borrow money in a portfolio and sell securities short without cost or limit. What an absurd assumption! Still, this assumption persists as the default for academics—largely because one must operate under the preferred paradigm of peer‐reviewers, though it also simplifies the math considerably. Yet, this kind of silliness also generates a map for investors that is so inaccurate as to be entirely useless to real people interacting with real‐world markets.

Building a proper map means we must first understand the people who are to use the map.

So, who are goals‐based investors? A goals‐based investor is, broadly speaking, any person or institution who has (a) specific funding requirements within (b) specified periods of time, and (c) some amount of wealth to dedicate to those objectives. Goals‐based investors are your co‐workers, your parents, aunts and uncles, friends, and your church. You are a goals‐based investor.

Goals‐based portfolio theory, then, is concerned with how to build an investment portfolio that delivers the maximum probability of attaining these real goals, given those inputs. If markets behaved as well as they do in theory (that is, if market returns were Gaussian), then most of those constraints would not matter. However, we know that markets are not so well‐behaved, so these constraints do matter—and matter quite a bit! This fact was realized decades ago, and even Paul Samuelson (the first recipient of the Nobel Prize in Economics) acknowledged that higher moments of return distributions (skew and kurtosis) matter to investors.¹ Mistimed drawdowns, as we all know intuitively, can destroy our ability to accomplish our objectives.

There are other important considerations. I know of no one who can leverage a portfolio without cost and without bound. Similarly, short‐selling is always limited in the real world—and not just by cost, but also by account type, regulation, and good, old‐fashioned prudence. In contrast with traditional theory, goals‐based investors are typically assumed to have no ability (or at least almost no ability) to short‐sell and leverage a portfolio. Additionally, since markets are not well behaved and a mistimed market drawdown can completely wreck a financial plan, goals‐based investors tend to be much more accepting of heuristics that can help protect a portfolio from the destruction that markets can bring upon the unsuspecting investor. And, as we shall see, this is not because investors do not like losses in the abstract; it is because goals‐based investors intuitively understand that portfolio losses lower their probability of goal achievement. Losses generate less wealth and less time to regain those losses, and markets can only provide so much upside in a subsequent recovery.

Jean Brunel, the father of goals‐based investing, enumerated another important distinction that is relevant here. When interacting with markets—whether public or private—very, very few individuals or institutions can be said to be price‐setters; we must generally be content to be price‐takers. And that distinction is important: price‐setters have the luxury of conforming markets to their own need, to meet their own objectives. The rest of us, by contrast, must be content to take prices, to approach markets as they are and not as we wish they would be. This distinction is important, but is also not immediately obvious.

Another challenge for goals‐based investors resides in the attitudes of those who fashion the tools and solutions. While our models of the world are very important, they also carry a danger. Much of academic theory, and even many practitioners, view markets as the equation on the page: x goes into the equation and y reliably comes out. But the real world is very messy, and we must account for that messiness, somehow. Goals‐based practitioners, then, must view the equation as only an approximation of markets: x goes into the equation and maybe y comes out, but z, m, and q might happen, too, so we should be prepared! Markets are not the equation, and they certainly are not reliable in any real sense of the word. We, as goals‐based investors and practitioners, must approach markets with a healthy respect. They can do much good, but they can also do much damage.

To put it as simply as possible: goals‐based portfolio theory is about using financial markets to achieve human goals, given real‐world constraints. Markets as they actually are is a real‐world constraint. As we will see, goals‐based investing is, in practice, not so simple. Unfortunately, real people and real‐world constraints make the portfolio management problem more complex, not less, and we have to leave behind many of the tools with which we are comfortable. But, were I lost in the jungle, I would much prefer a map maker who erred on the side of too much detail, rather than too little.

A full understanding of goals‐based investing begins with an understanding of the goals‐based investor. More than any other point made in this book, I want to stress this one: every investor is different. If you, practitioner, are to do your job correctly, you absolutely must begin with a thorough understanding of your investor. We cannot treat each investor like all the rest. Each investor has her own panoply of goals, her own tax situation, her own career, her own levels of wealth. Each investor has her own moral constraints.

Traditionally, our business has focused on the investment aspect of our role, to the exclusion of pretty much all else. I recall how I was trained on financial planning early in my career. Rather than central to the process, financial plans were viewed as a sales tool. Whoever owns the plan owns the client, Use the planning process to uncover more assets, and Plan for what they need, but close with what they want, were all common phrases. Talk about cynicism!

To be fair, this is how the business of wealth management saw the value they added: investing financial assets, not building and executing holistic financial plans. How could it be any different? In the end, the final investment decision was made by giving clients a risk‐tolerance questionnaire, and the portfolio managed by some far‐off investment committee. Risk tolerance is the only human input into the traditional portfolio optimization equation, anyway, and we cannot forget that it is a metric that regulators obsess over. Financial planning, though intuitively obvious, was superfluous in practice because