Imagine for a moment that you owe a violent loan shark $10,000 by tomorrow morning. But today you have only $7,000.
Now suppose you visit an economist for help. You desperately ask, “What am I to do?!”
Our economist, being highly trained, administers a risk-tolerance questionnaire to gauge your preferences about risk. As it turns out, you are pretty risk averse.
“There is nothing I can do,” our economist sadly concludes. “There just isn’t enough time for a low-fee 60/40 portfolio to earn 43% by tomorrow.”
As silly as all this sounds, your debt to the shadow economy financier illustrates the failings of traditional theories for utility and, by extension, the portfolio theory which is built upon them.
Behavioral finance has filled this gap, offering models for how people actually behave. But that has done little to dispel the argument that people still behave irrationally. If you want to behave rationally, the logic goes, you still need traditional utility theory.
But what if our traditional models of choice simply aren’t measuring people’s true objectives? What if people are just a little more rational than we previously thought?
This is where goals-based utility theory attempts to bridge the gap between normative and behavioral finance. By modeling people’s actual goals, all of their resources — wealth included — become tools to accomplish those goals rather than ends within themselves. Rather than being always and everywhere variance averse, goals-based utility theory shows that preferences toward portfolio variance depend on the situation.
So, back to the subject of your $10,000 debt and its pay-by date. Under a goals-based paradigm, after exhausting all other options, our economist may rightly recommend you head to a casino and gamble that $7,000 in hopes of winning the extra $3,000. Because anything less than $10,000 is a hospital visit, high-variance outcomes are your only hope.
As crazy as it sounds, gambling, even with a negative expected value, is the rational choice in this context. I know, this is blasphemy!
Risk-tolerance questionnaires in cases like this are also entirely superfluous. Traditionally, they attempt to assess someone’s aversion to portfolio variance. Variance aversion is the lone human input in mean-variance optimization, and while some believe the questionnaires that measure this are ineffective, there is simply nowhere to input that variable for goals-based investors. Make no mistake, optimizing the achievement of goals requires many human variables — time horizon, current wealth, relative goal values, and so on — but how you feel about portfolio movement isn’t one of them.
This should not come as a shock. Imagine going to a medical doctor for a battery of tests and physical inspections — only to find out that the sole metric for determining your treatment is the pain-tolerance questionnaire your doctor administered at intake. Why complete any financial planning work at all if variance aversion is the only relevant variable?
Fundamentally, goals-based portfolio theory seeks to fuse the financial planning and money management processes. Most of the time, optimal goals-based portfolios will match optimal mean-variance portfolios, but not always.
For example, high-variance investments, which have been more or less eliminated from optimal mean-variance portfolios, may yet have a role to play for goals-based investors. Behavioral finance predicts that individuals will have aspirational goals, but it offers no “shoulds” with respect to them: For example, you should dedicate $xx to this goal and you should invest in this portfolio to achieve it, etc.
Traditional finance constrains away aspirational goals by mandating a portfolio’s expected return be greater than the goals’ required return. But what are aspirational goals if not return requirements that are much larger than those offered by traditional investments? Goals-based investment theory not only acknowledges these goals, it provides budgets and portfolios for them.
In the end, goals-based investing is simply about using financial markets to achieve your goals under real-world constraints. But that can only happen by first understanding and modeling the objectives you’re actually trying to achieve. Investing is not about managing variance and return, it is about achieving goals. Portfolio variance and returns are inputs to that equation, but they are not the equation.
Modern portfolio theory, then, is mostly right. It just isn’t quite right.
It is wrong about eschewing high-variance, low-return investments always and everywhere. It is wrong about using variance-aversion as the only input for optimal portfolios. It is silent when asked how you should divide your funds across your goals.
In the end, if you have goals to achieve, you should be a goals-based investor. Indeed, if you owed $10,000 to a violent loan shark, which tools would you reach for?
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Smileus
