Goals-Based Investing Saves Investors from Rash Decisions

The market upheaval we’ve been seeing for weeks now has sent a significant number of investors into a panic (see Market Events, page 4). What does panic look like for a wealth manager? It’s a phone call from a frantic client saying “sell my stock” or “liquidate my entire portfolio.”

In a previous article entitled Aligning Life to Wealth: An Introduction to Goals-Based Investing, I mentioned behavioral biases.

These are common human tendencies that lead us to make decisions that may hurt us in the end—like selling off investments in a panic. While the urge to panic is understandable, it is absolutely counter-productive. Jumping out of a falling market may help us avoid some rocky days ahead, but the there are plenty of reasons to resist that urge. For instance, we’re likely to incur serious losses by selling good investments at prices temporarily deflated by market upheaval. And the chances of knowing when to jump back into the market to avoid missing the eventual recovery are slim to none. Ultimately, making rash decisions may jeopardize the likelihood of reaching the goals we’ve set for ourselves—the reasons we’re investing in the first place. The challenge, therefore, is to avoid panicky reactions even when the situation is unsettling. This is where Goals Based Investing (GBI) comes in.

Goals-based investing, revisited

To recap briefly, GBI begins with clients identifying specific life goals for which they are investing. Individual asset pools, each with its own tailored investment strategy, are then established for each goal (or group of goals with similar characteristics). So, for example, the investment strategy for an asset pool established to support a couple’s lifestyle over the next five years will be quite different than that of the asset pool intended to serve as a gift to the couple’s grandchildren in a couple of decades. The former investment strategy will aim to create a steady income, while the latter pool may be invested more aggressively to achieve maximum growth over a longer period. The separation and investment of assets by goal also helps investors see clearly how they are progressing toward each of those goals.

In contrast, traditional investment approaches typically rely on a single pool of assets with one investment strategy intended to yield the necessary overall return without exceeding the investor’s tolerance for risk and volatility. In this case, it becomes extremely difficult to measure progress toward any single goal.

One of the fundamental tenets of goals-based investing is that it strongly discourages those behavioral biases that I described earlier; in fact, it guards against the negative behaviors that lead to poor investment performance over time. The clarity and sense of purpose gained through the process of identifying concrete life goals, assigning assets and choosing investment strategies for each of those goals, creates a rational context for making future decisions which result in more measured actions on the part of investors; the context provides greater peace of mind. So, when the market goes awry, goals-based investors are less likely to panic. They look at the situation in terms of how it might affect the likelihood of reaching each goal, and make decisions around asset pools and related investment strategies in that context. In short, they’re much less likely than traditional investors to call and ask us to “sell everything.”

Validating GBI's Ability to Provide Clarity and Context

The current market conditions offer the perfect opportunity to stress-test (emphasis on stress) that last claim—that goals-based investors are less likely to panic and make ill-informed changes to their portfolios when the market is unstable. We studied our clients’ reactions to the market upheaval, as measured by changes in portfolio strategy from the beginning of September 2008 to mid-October 2008 and compared the reactions of clients invested in goals-based strategies to those taking a more traditional approach. Consider the following statistics.

Of those clients who have a single, traditional investment portfolio:

• 50% decided to fully liquidate their entire portfolio or to liquidate the entire equity portion of their portfolio. This group included some of our wealthiest clients who did not need to liquidate their portfolios to cover their expenses over either shorter or longer time periods. These clients were emotionally distressed by the conditions of the markets and engaged in one of the biases outlined above–they overreacted to the markets. They chose to interpret risk exclusively in terms of market volatility. They chose not to consider interpreting risk from other perspectives, including their ability to meet their goals over both shorter and longer periods of time.
• 10% made a significant change to the allocation of their portfolios, by reducing equity exposure by more than 25%, in an effort to time the market. While in the short-term their portfolio performance has been positively impacted by their most recent decision we know that market timing is a difficult game to win and we can only measure its effect over a full market cycle.
• 20% decided to adopt a goals-based approach to investing. These clients had been talking with us about our goals-based approach for some time, but had never recognized a compelling reason to make the change. The market events helped to reinforce the rationale behind our process of identifying concrete life goals, assigning assets and choosing investment strategies for each of those goals. They each began the process with the creation of their current lifestyle asset pool, a pool intended to fund targeted annual lifestyle expenses in the short-term, typically two-three years.
• 20% decided to make no changes to their portfolios. This group of investors was dominated by family offices whose portfolio decisions are made by professionals who function more like institutional investors and less like individual investors. Therefore, it is not atypical for them to act and react differently to market fluctuations. Overall, their perspective on the markets is unique among our clientele.

Of those clients in a goals-based investment strategy:

• 20% decided to increase the size of their current lifestyle asset pool by the equivalent of about one additional year of expenses. While these clients increased the amount of cash in that pool to offset the negative impact of the market volatility, they left their longer-term assets fully invested.
• 75% have made no changes. Note: We are still talking with clients in this group and some may end up making similar changes to their lifestyle asset pools.
• 5% were only in the initial stages of investment implementation and decided to hold off until the markets stabilize, keeping their assets in cash.

I should note that we evaluated all of this data to ascertain whether variables like age and amount of wealth contributed to the differences in behavior that we were observing, but found no conclusive evidence to that effect.

The results of this analysis support our assertion that clients using a goals-based investment approach are less likely to liquidate or make other dramatic changes to their investment strategies. That small percentage of clients who did make changes did so as the result of a rational decision-making process in which, together, we revisited their goals, the related assets pool, and the investment strategies assigned to each. Their actions were precise and had very specific intentions, unlike those clients with traditional portfolios who made sweeping decisions to liquidate.

Conclusion

As expected, GBI clients’ current lifestyle pools (with relatively low equity exposure), have fared better than their longer-term investments, which are more heavily weighted to equities. While equities have taken a beating, our GBI clients recognized that completely or partially liquidating assets like equities from their longer-term pools would put their longer-term goals at great risk. In fact, following the traditional investment rule of thumb—buy low and sell high—many clients with excess resources have been looking for buying opportunities.

We’ve been having frequent conversations with all of our clients during this time of uncertainty, but our discussions with GBI clients remain focused on their goals and the progress we’re making toward realizing them—not on investment performance. This highlights one of the key differences between goals-based investing and traditional investing.

The overarching intention of GBI is not to get the greatest overall return for a portfolio. The goals-based approach is aimed at enabling clients to relate their wealth to their life goals and see how they’re progressing toward those goals. By creating the proper context in which to make rational decisions, clients demonstrate greater comfort with and commitment to their investment strategies and are less likely to behave impulsively. Ultimately, our GBI clients tell us they feel a real sense of empowerment with respect to their wealth.

Greater clarity of purpose and confidence in your investment choices won’t completely prevent disappointment when markets fall precipitously like they have in recent weeks; but clients will be better prepared to weather these events and more likely to maintain perspective and discipline if they are focused on their goals.

The SEI Wealth Network is an “umbrella” name for various life and wealth advisory services provided by your personal business manager and SEI Investments Management Corp. (SIMC).

This material represents an assessment of the market environment and your personal situation at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results. The examples provided are based on individual situations and goals and should not be construed as investment and/or tax advice.

SIMC is a wholly owned subsidiary of SEI Investments Company.