Q2 2013

On Apr 03, 2013 In Goals-based Investing 

I-Harmony: Marrying Investment Goals and Assets

The goals-based approach to investing seeks to maximize the probability of achieving each investor's unique financial goals. This framework recognizes that certain goals have a higher priority than others, and that higher priority goals should be funded with portfolios exhibiting less variability or uncertainty in their future outcomes. In portfolio construction, investors should strive to marry their investment portfolio with their goals in what ought to be a harmonious, stable, long-term relationship.

The time horizon and priority level of the investor's goals are the primary measures of compatibility in this marriage. To illustrate, let us assume that an investor has three personal financial goals, as illustrated below. We further assume that the investor can choose to allocate his capital into one or more of the following portfolios, A through D1 (see illustration).

The question at hand is relatively straightforward: "Which of the four portfolios—A, B, C, or D—would maximize the probability of achieving the investor's three goals?" The answer can be complex, in that each of his three goals may be funded ideally with a different portfolio, based upon the priority level and time horizon of each respective goal. The investor's desire to "Fund Ongoing Lifestyle" is labeled as a "high" priority, which implies that the investor needs to have a high degree of confidence that the desired dollar amount is available on the anticipated date to fund the stated goal. The "Build New Beach House" goal is assigned a "medium" priority and the "Make Gift to College Alma Mater" goal is labeled as a "low" priority, implying that the investor's pain of loss—were he to fail in achieving these goals—would be much less than if the higher priority goals go unmet.

A very pessimistic investor might fund his future goals today in a dollar-for-dollar fashion; that is, he might deposit $15 million today ($500,000 x 30 years) to "Fund Ongoing Lifestyle," $3 million to fund his "Build New Beach House" goal, and $1 million today to "Make Gift to College Alma Mater," which together sum to an upfront deposit of $19 million to fund future goals. Unexpected longevity and inflation might derail this simplistic plan.

A more sophisticated approach would be to ask, "Which portfolio allows the investor to fund his future goals with the fewest upfront dollars while recognizing the desired goal's priority level and time horizon?" Answering this question requires the following logical progression:

a) The higher the goal's priority, the higher the confidence level required that the portfolio will deliver the needed funding on time.
b) The higher the required confidence level, the less risky should be the portfolio that funds the goal.
c) The less risky the portfolio assigned to fund a particular goal, the lower the expected return at any given time horizon.
d) The lower the expected return on a particular portfolio, the more dollars need to be invested today to fund that future goal.
e) The ideal portfolio to fund a particular goal is the one which minimizes the upfront cost of funding that goal.
f) The portfolio which minimizes the cost of funding a future goal is that which offers the highest expected return at the desired confidence level at the appropriate time horizon.

We can forecast the expected return for different portfolios at various confidence levels and time horizons, allowing us to identify which portfolio is ideal for funding various goals. The following chart illustrates how this process of portfolio idealization might guide us in portfolio selection (see illustration)

For goals of a similar time horizon, lower priority goals can be funded with riskier portfolios. Since those portfolios have a higher expected annual return, the cost of funding these lower priority goals is less in present value terms. Similarly, for multiple goals of an equal priority level, longer-term goals can be funded with the riskier portfolios, which because of their higher expected returns will require fewer upfront dollars to endow. The investor's overall portfolio—encompassing all of his goals across time horizon and priority—is calculated as the weighted average of all the individual portfolios selected to fund each specific goal.

Eton's goals-based framework marries investment portfolios with unique personal financial goals. Goals change over time, both in their definition and their priority. Financial markets also change over time, requiring investors to periodically revise their family goal matrix and re-examine their choice of ideal portfolios to fund family goals. Like all long-lasting marriages, flexibility is required to keep the investment portfolio in close compatibility with changing goals, needs, and circumstances.

1 For illustrative purposes only. These portfolios are not intended to represent the benchmark portfolios of Eton Advisors, LP and are not intended as recommendations to any individual investor or family.

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