Aligning Life and Wealth: An Introduction to Goals-Based Investing

Based on concepts discussed in “Goals-based Investing: Integrating Traditional and Behavioral Finance,” by Dan Nevins of SEI¹

When I was a kid, my parents had a drawer full of envelopes with words like clothing, food and savings scratched across the front. Every payday they’d tuck cash into those envelopes to cover the family’s monthly expenses, starting with the most critical and trickling down to the nice-to-haves. This was their system for managing money— not particularly sophisticated, but they always knew where they stood.

The envelope system was common in the era before computer-based money management programs. If you think about it, the new programs use the same kind of logic; they manage money in part by dividing it into a variety of spending and saving categories. These practices— from paper envelopes to digital ones— persist because they’re consistent with the way most people think about their money. Behavioral finance theorists (experts who study the psychology of financial decision-making) call it “mental accounting.” In studies of investment practices, they found that people tend to regard their wealth not as a lump sum, but as distinct amounts needed to meet individual goals. Furthermore, they make decisions differently for different types of goals, including decisions about how aggressively or conservatively they want to invest.

While it’s natural to think about wealth in mental accounting terms, it’s far from a neat and logical process. Once they get past the most obvious needs, people frequently struggle to be clear about what they really want—for themselves, their families or their communities—and to decide the importance and urgency of each.² Most have ideas, but some think too narrowly, focusing only on goals that are immediately apparent. Others underestimate the resources at their disposal, missing opportunities to realize bigger dreams. Our brains may be wired for mental accounting, but it takes time, motivation and a lot of information to execute a comprehensive strategy.

Unfortunately, traditional investment practices don’t provide much help. They assume that with a minimum of questioning, clients know exactly what they want in their lives. Traditional investment practitioners also tend to generalize. Rather than considering the differences in urgency, comfort with risk, and the relative importance of individual goals, traditional practitioners lump them together and attempt to satisfy all of them with a single investment strategy. Behavioral researchers Shefrin and Statman [2000] and investment practitioners Brunel [2003] and Nevins [2004] agree that traditional investment practices commonly used today are not well aligned with the way individual investors actually think and behave. They propose an alternate approach called “goals-based investing” that applies the findings of behavioral research to traditional investment practices, reorienting the entire process around discovering and satisfying an investor’s multiple life goals.

Multiple Goals, Multiple Strategies

Here’s an example that illustrates the differences between a traditional investment approach and a goals-based investment approach:

Grace and her husband George have built substantial wealth, but they couldn’t honestly tell you what they have, where it’s located or whether it’s enough to let them to do everything they want to do. This out-of-control feeling has nagged at them occasionally, but they’ve been too busy to pay much attention. Lately, however, the nagging has grown more insistent because the couple is poised to increase their real estate holdings. They‘ve found a large piece of land where in addition to building a home for themselves, they plan to build homes to accommodate their extended family.

They've been talking about doing this for years, but now that they’ve found the right property they realize they’re facing another set of issues. This will be a large, long-term investment. Even with their sizeable wealth the couple can’t imagine how they’ll manage such a big project without downsizing or abandoning other plans. They need some help.

If Grace and George turn to a traditional wealth manager, they’ll be asked to provide data about their current financial situation and spending patterns, as well as any particular goals they can identify. After tallying up the expected costs of the couple’s goals, the traditional wealth manager will assess how much risk and volatility the couple can tolerate when it comes to their overall investments. With this information, she’ll develop an investment policy, determine the annual return needed to fund the goals Grace and George told her about, and recommend an investment strategy: a mix of asset classes most likely to yield the necessary returns without exceeding the couple’s tolerance for risk and volatility. Once the strategy is implemented, the couple will receive regular statements for their investment account.

This approach has a number of shortcomings:

• It assumes that Grace and George recognize all of their goals. Only the goals the couple is aware of are considered when devising the investment strategy.
• There is no differentiation among the goals with respect to their relative urgency or priority. All goals carry equal weight.
• One investment strategy can’t adequately accommodate the different time horizons and differing priorities of each of the goals. The wealth manager will settle on some middle ground that satisfies the goals in aggregate.
• The couple won’t know if they’re progressing toward achievement of each of their goals. They’ll see only one investment account that is either growing or not, along with a comparison of its performance to benchmarks like the S&P 500.

If Grace and George turn to a goals-based wealth manager, however, not only will they talk about the goals they’ve identified to date, they’ll be challenged to think bigger and dig deeper. Once all of their dreams are on the table, they’ll prioritize and set timelines, a process that drives the couple to think even more carefully about the relative importance and urgency of each goal. The goals-based wealth manager facilitates these discussions, helping Grace and George to identify their hopes and concerns and decide how opportunistic or conservative they want to be with respect to each goal.

Next, the goals-based wealth manager will develop a clear picture of all the resources Grace and George have at their disposal; including investments managed by firms other than her own, non-liquid assets like real estate and art collections and non-financial resources like expertise or time. She’ll review their current spending patterns and consider how potential changes in family circumstances are likely to affect the couple’s spending throughout their lives, basing that evaluation on her knowledge of Grace and George’s plans, as well as spending trends among couples with similar characteristics and wealth profiles. With all of this data, she’ll figure out whether it’s feasible to achieve Grace and George’s goals in the given time frames or whether tradeoffs are necessary. It may be necessary, for example, to extend the deadline for achieving one particular goal or sell a real estate holding to fund another. After discussing all the options with Grace and George, their wealth manager will create investment policy guidelines for each goal, and a plan for organizing their wealth into multiple asset pools, each with a unique investment strategy aimed at achieving its related goal³.

After a final approval from the couple, the goals-based wealth manager will begin to execute the agreed-upon investment strategies. The process doesn’t end there, however. Knowing that change is inevitable, the wealth manager will stay in close contact with the couple, regularly reviewing resources, goals and priorities and making adjustments if something changes significantly in the couple’s life or circumstances. Grace and George will receive reports that show how each investment strategy is tracking toward its related goal and will meet regularly with their wealth manager to review progress.

Beyond correcting the deficiencies of traditional investment practices, goals-based wealth management gives clients a framework for making investment related decisions as well as a tremendous sense of clarity regarding goals, priorities and resources. As a result, goals- based investing:

• Increases clients’ commitment to their goals and reduces impulsive decision-making. Clients will be able to see how
  a proposed change might affect the likelihood of achieving one or more of their goals.
• Helps clients see how they are progressing toward each of their goals, as opposed to seeing only how investments are performing
  against benchmarks like the S&P 500.
• Creates a sense of purpose and empowerment; eliminates that out-of-control feeling.

Furthermore, by regularly monitoring and reviewing goals, priorities and plans, the goals-based wealth manager helps to ensure that the couple will remain clear about what’s important to them. They’ll continue to feel a deep sense of confidence that their wealth is working to help them achieve what they want out of life.

The Right Wealth Manager

The practice of goals-based investing is still in its relative infancy among investment practitioners, but there are some out there who embrace this new approach. Potential clients should keep in mind that a goals-based wealth manager should:

• Help clients envision and state their goals—both the everyday and the more aspirational goals—and encourage them to think beyond
  immediate concerns to the kind of impact they want to have on family and community.
• Help clients understand their attitudes about each goal and facilitate a discussion of relative priorities and timeframes.
• Have a frank discussion with clients about the feasibility of achieving their goals and any trade-offs or compromises that might be necessary.
• Look at all resources at a client’s disposal—from art collections to investments—whether managed by her firm or not.
• Create distinct asset pools with unique investment strategies aimed at achieving each individual goal. Some wealth managers may claim to practice goals-based investing and do a good job of assessing goals, but end up creating a single investment strategy.
• Show clients how their investments are tracking toward individual life goals, not just whether their investments are underperforming or outperforming an industry benchmark.
• Help clients delve more deeply into their life goals to identify issues they may not even have considered. For example, a couple who hopes to establish a private foundation will obviously be concerned about the investment and tax aspects of the endeavor. But does the couple share the same vision of what the foundation should become and what it should achieve? Are they unconsciously hoping that the project will help to give their children a greater sense of purpose?

A goals-based wealth manager should help clients recognize needs and expectations they haven’t yet considered.

The traditional principles of investing have been the backbone of portfolio construction and management for decades, and many of the fundamentals are still important. But, the traditional approach can be improved upon by practitioners willing to reorient the entire process around a client’s life goals, and the approach is slowly but surely taking hold in the investment community.

We encourage clients to question potential wealth managers about the goals based approach, or to discuss its obvious benefits with their current wealth managers.

Behavioral Biases: Saving us From Ourselves

Goals-based investing accommodates the way investors think and behave. Interestingly, the same approach will thwart some of our natural tendencies—specifically those that could hurt us in the end. Behavioral finance theorists have studied a number of common behavioral traits best characterized as “biases,” which can lead to failed investment strategies and must be controlled. Following are several examples of potentially damaging biases.

Overconfidence is the tendency to overestimate our ability to predict market events. This bias leads to over-trading, as we try to work the market to our advantage, which results in poor investment decisions and high transaction costs. In fact, studies show that portfolio performance is inversely related to the amount of trading in the portfolio (Barber and Odean [1999, 2000]). Hindsight Bias is the belief that we’ve predicted an event when, in fact, we didn’t. It’s not a matter of bragging; we are honestly deceived when we claim we had expected the event would occur (Kahneman and Mark Riepe [1998]). Hindsight reinforces a tendency toward overconfidence, and we’ve already covered the dangers of that particular bias.

Overreaction is a tendency to be overly influenced by random occurrences. The human mind is a pattern-seeking machine and we’re strongly biased to assume that there was some cause at work behind any notable sequence of events (Kahneman and Riepe [1998]). As a result, we may over-interpret patterns that are actually coincidental and unlikely to persist. Overreaction is often at work when we’re tempted to buy high or sell low.

Belief perseverance is our penchant for sticking to our guns even when contradictory information comes to light (Lord, Ross and Lepper [1979]). Two effects appear to be at work (Barberis and Thaler [2003]): a reluctance to search for evidence that contradicts our beliefs; and the tendency to be skeptical even when contradictory evidence is presented. This bias may cause us to cling to a poor investment strategy despite strong signs that it’s not working.

Regret avoidance is the inclination to avoid actions that could make us feel uncomfortable about decisions we made earlier—even though the actions we’re avoiding might be in our best interest. This bias can explain the fact that investors commonly hold onto losing investments longer than they keep winning ones (Shefrin and Statman [1985]), Odean [1998]).

These biases were widely recognized by social scientists long before the emergence of behavioral finance, and investment advisors see them regularly in their own practices. Yet the investment community’s track record for dealing with them is questionable, perhaps because so many practitioners are still bound to the principles of traditional investment theory.

Goals-based investing makes it difficult for damaging biases to take hold because our personal goals and preferences form the criteria around which our investment strategies are built. The focus shifts from market performance to progress toward our goals. In other words, because the strategies we selected are perfectly aligned with what we’re trying to accomplish we’ll be less tempted to follow the latest market trends or test new investment vehicles that seem to be promising. There’s no need for tinkering.

Of course, those who really want to tinker (and have the excess capital to do so) could set up an asset pool specifically for that purpose. In general, however, market adjustments should be left to an expert investment practitioner who will continually reevaluate the securities that make up each of our asset pools to make sure they’re always comprised of the best vehicles to achieve the associated life goal. In fact, a goals-based investment advisor will encourage us to make adjustments to the strategies themselves only when goals or fundamental circumstances—the assumptions upon which a strategy was built—change.

Greater confidence in our strategies and clarity of purpose won’t completely prevent disappointment when markets fall; but we’ll be better prepared to weather these events and more likely to maintain perspective and discipline if we’re focused on our goals.

¹ “Goals-Based Investing: Integrating Traditional and Behavioral Finance” by Dan Nevins, published in the Journal of Wealth Management, Volume 6, Number 4 (Spring 2004).
² For more on identifying and prioritizing goals, see “Do you Feel Stuck?.”
³ Goals with very similar characteristics (including risk tolerance) may be grouped together and assigned a single investment strategy, if appropriate.

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). Components of these services and programs may be offered by SEI subsidiaries and non-affiliated third parties. SIMC is a wholly owned subsidiary of SEI Investments Company.

The story represents a hypothetical based on a composition of multiple client experiences and issues and SEI’s proposed solutions. This is intended to illustrate the different services provided by SEI Investments Management Corp. and is not meant to guarantee that a client’s needs or objectives will be met.