Goals-based Investing: Integrating Traditional and Behavioral Finance by Dan Nevins
Executive Summary (Via Alden -International)
This article examines opportunities to improve wealth management for individual investors by combining traditional investment methodology based on modern portfolio theory with the observations of behavioral finance. Particular areas of focus include new frameworks for risk measurement and riskprofiling, and methods for managing behavioral biases. Our key points include:
1. In the area of risk measurement, we stress the importance of capturing investor goals and preferences and propose several measures that are consistent with this objective. Proposed risk measures differ from traditional measures in that they are based on events and do not require specification of a time interval.
2. We critique common risk profiling techniques, advocating separate risk tolerance estimates for separate goals rather than an overall risk tolerance for each investor.
3. We note that the “total portfolio” framework of traditional finance is inconsistent with investors’ tendencies towards mental accounting and suggest that a better result may be achieved by linking individual strategies to a specific goal or goals.
4. The benefits of aligning strategies with goals are also discussed in the context of behavioral theory, with the argument that behavioral biases are more easily managed with this approach.
5.Furthermore, we argue that performance measurement for individual investors becomes more meaningful when strategies are evaluated based on progress towards goals rather than using traditional portfolio statistics.
Together, our recommendations comprise a framework for goals-based investing. The implementation of this framework is described through examples, which consider the challenges of investing to meet lifestyle expenses and investing for a fixed planning horizon. We discuss the development of investment strategies for each of these purposes, modifying traditional portfolio construction methods to reflect investor goals, risk tolerances and preferences.
According to our research, our goals-based investing framework delivers better solutions than traditional approaches. Our approach increases the likelihood of achieving specific goals while heeding the lessons of behavioral finance by capturing the ways that investors think and behave. We conclude that goalsbased investing is an important step towards narrowing the gap between the investment principles of the practitioner and the perspective of the individual investor.