A recent paper A New Approach to Goals-Based Wealth Management published in the Journal of Investment Management (JOIM), provides a very comprehensive framework for a Goals-Based Wealth Management approach.
Behavioural Economics forms the foundations of Goals-Based Wealth Management.
As the JOIM Paper notes “Traditionally, the ﬁnancial industry, ﬁnancial advisors, and academics in ﬁnance have associated the notion of “risk” with the standard deviation of an investor’s portfolio. Investors, on the other hand, typically associate “risk” with the likelihood of not attaining their goals.”
This is important from the perspective of client communications: “In traditional ﬁnancial planning, advisors look to understand what an investor’s goals are, then they ask questions designed to determine the investor’s tolerance for portfolio standard deviation, which leads to advising the investor to adopt a portfolio that has a mean and standard deviation corresponding to the investor’s risk appetite”
Goals-Based Wealth Management is defined “as a process that focuses on helping investors realize their goals, both short-term and long-term,..”
Behavioural Economics comes into play by “using language and ideas that are more natural for investors” in determining appropriate investment goals.
Behavioural Economics Foundations
The JOIM Paper provides a very good overview of the behavioural economics that forms the foundations of their Goals-Based Wealth Management Investment solution.
Inputs comes from the:
- pioneering and very influential academic literature on Behavioural Economics
- growing practitioner literature on goals-based wealth management
Richard Thaler’s work, who is a 2017 Nobel prize winner for his contribution to Behavioural Economics, provides a central pillar to the Goals-Based Wealth Management solution outlined in the JOIM Paper.
Thaler’s worked on the “endowment effect”, which is the asymmetric valuation of assets by individuals. Namely, individuals value items more when they own them as opposed to when they do not.
This is related to loss aversion in Prospect Theory. Loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains. Some studies have suggested that losses are twice as powerful, psychologically, as gains. Loss aversion was first identified by Amos Tversky and Daniel Kahneman.
Mental accounting theory is also a significant contribution from Thaler and it is also an essential foundation for Goals-Based Wealth Management.
Mental accounting is where people treat money with different risk-return preference, depending on what use the money is to be put to. It is a way of keeping track of our money related transactions.
From a practical perspective, mental accounting helps elicit investors goals, and is “facilitated by breaking down overall portfolio goals into sub-portfolio goals using the ideas of mental accounts, where different goals are managed in different accounts, each aggregating into the overall portfolio.”
Lastly the JOIM Paper notes the work undertaken that developed Behavioural Portfolio Theory. This theory postulates that investors behave as if they have multiple mental accounts. “Each mental account portfolio has varying levels of aspiration, depending on the goals for the mental account. These ideas naturally lead to portfolio optimization where investors are goal-seeking (aspirational), while remaining concerned about downside risk in the light of their goals. Rather than trade-off risk versus return, investors trade off goals versus safety…”.
The JOIM Paper also notes the growing practitioner literature on goals-based wealth management.
Specifically, they reference three major contributions:
Nevins advocates a goal-orientated approach to help investors deal with biases such as overconfidence, hindsight bias, and overreaction. Nevins’ work extended the mental accounting approach. He also argues that traditional investment planning fails to recognize investor’s behavioural preferences and biases.
Contributions by Zwecher, complements Nevins, he argues that risk management can be “done more actively and efﬁciently by demonstrating how a retirement portfolio that provides income, generates growth, and protects assets from disasters, can be created by adopting a bucketing (mental accounting) approach.”
Research undertaken by Brunel discussed the equal importance of two goals for an investor: being able to avoid nightmares while realizing dreams. “Brunel’s work focussed on demonstrating how goals-based wealth management can be achieved across multiple time horizons for multiple life goals. He also suggested how to map the language customers use in describing the importance of dreams or the severity of nightmares into acceptable probabilities that the investor will realize such dreams or avoid such nightmares.”
In short, Practitioners have recognized the need for a goals-based approach.
The premise is, if customers can better articulate and discuss their goals, including safety, then they are able to work with Practitioners to build more robust investment solutions that are better designed to meet their aspirations and investment objectives.
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