Asking clients about their objectives is not goals-based investing.

Know-your-client practices restrict asset allocation to what investors have (assets) and know (investment experience), rather than what they need (e.g., tuition in 18 years). But your clients’ long-term goals might benefit from a riskier mix of assets over time (say, 80% equities and 20% bonds).

Selecting portfolios based on overall risk tolerance, investment knowledge, experience, cash flow, net worth and time horizon—standard procedure at most firms and encouraged by regulators—doesn’t mean investors’ financial goals are necessarily addressed.

You’ve probably had clients who needed to take more risk than their profiles indicated to achieve their desired goals. For clients approaching retirement with insufficient capital, saving more might not be a viable option, and starting earlier certainly isn’t. The only practical alternatives are working longer and spending less, but these restrictive options have limits. And investment choices narrow when compliance departments flag overly aggressive asset mixes or products.

What can you advise?

Under conventional portfolio construction

You could focus on maximizing returns and hope that goals are met as needed. But modern portfolio theory (MPT), the preferred approach for maximizing returns, can’t address contingent liabilities—planning, saving and investing to meet needs. In “A closer look at goals-based investing” (see AER September 2017), we observed that MPT’s dependence on expected returns, risk (standard deviation) and correlations between holdings means that small errors can lead to magnified distortions. Accumulating capital over time can be approximated by compounding assumptions, like 7% for annual equity returns. But estimation errors can mislead investors into under- or overestimating their requirements.

Under goals-based portfolio construction

Setting goals and working toward achieving them is a better choice. You might think you already do this by asking clients about their financial requirements. But the best test is whether you can report to clients using a goals-centred report that shows how their objectives are being addressed. Table 1 is a good example.

With this type of reporting, investors see their progress toward goals. In this case, eldercare and college are covered, but retirement needs to be discussed. When markets are unsettled, reporting this way can help ease concerns.

Table 1: Goals-based portfolio allocation

Table 1: Goals-based portfolio allocation

Build a goals-based portfolio

  1. Categorize client goals as essential or aspirational. Determine when funds for each are needed (see Table 1). Time distinguishes the truly wealthy from all other investors. The wealthy can afford to stay invested for the long term, but everyone else needs to plan, save and invest to meet specific financial needs at specific times. We use a risk score to communicate the idea of time and risk. A score of 5 indicates:
    • a time horizon of five years, at the end of which the minimum return should be return of all capital plus inflation, with a 95% probability; and
    • a worst return of -5.0% in any 12-month period during those five years, and a 99% chance the portfolio won’t fall below this floor.Establishing a return floor gives investors confidence that losses can be contained.
  2. Build a safety portfolio based on time horizons. The safety portfolio here (Table 1) is assigned a risk score of 5, but an all-cash score of 0 also works. For practicality, all time horizons shorter than five years are given a risk score of 5.
  3. Build a growth portfolio. In Table 1, the investor has a 40% safety and 60% growth portfolio. To more accurately reflect the amount of risk required to address all goals—retirement in particular—the growth portfolio needs a higher risk score (30) than the one illustrated (24). This is the main reason that goals-based portfolios must be customized. Every investor’s goals are unique: different time horizons and amounts make for more complexity. A barbell approach to risk is an elegant way to handle this challenge. Just as a bond portfolio’s duration can be managed by shifting between cash and a long bond—like two weights of a barbell—so can risk be controlled by moving between the safety and growth portfolios. Growth portfolios with risk scores of 20 and 30 are shown in Table 2.

ETFs were selected primarily for their low cost. For simplicity, each portfolio is limited to five holdings. The duration of the fixed income part of the safety portfolio is under five years, below the FTSE TMX Canada Universe Bond Index’s 7.4 years. That shorter duration reflects the view that higher interest rates are more likely over the portfolio’s time horizon.

The exception is the Growth 30 portfolio, which uses emerging market bonds to add volatility and return potential. Its duration is 5.4 years—higher than that of the Growth 20 portfolio but still below that of the FTSE benchmark.

As market volatility changes, the weights within safety and growth portfolios will change to maintain as close to a consistent exposure to risk as possible. This approach is designed to protect against significant market weakness and take advantage of the skew in market returns (see AER September 2017).

Table 2: ETF allocation

Ticker Safety (risk: 5) Growth (risk: 20) Growth (risk: 30) MER
Horizons S&P/TSX 60 Index HXT 5% 27% 25% 0.03%
Vanguard S&P 500 Index VFV 5% 22% 25% 0.08%
BMO MSCI EAFE Index ZEA 5% 22% 25% 0.22%
iShares Core Canadian Short Term Bond Index XSB 58% 20% 0.10%
Horizon Canadian Select Universe Bond HBB 27% 10% 0.10%
iShares Core MSCI Emerging Markets IMI Index XEC 10% 0.26%
BMO Emerging Markets Bond Hedged to CAD Index ZEF 15% 0.56%