A Behavioral Perspective on Goal-Based Investing
Based on our many years of talking with clients about what motivates their investing decisions, discussions about investors’ goals stand out as some of the most enlightening conversations any advisor can have. This conversation often provides a clear sense of what is important to a client and helps clarify why, or indeed whether, the client should be investing in the first place. By framing personal wealth in terms of what the client wants to use that wealth to achieve, an advisor can channel the client’s emotions and decisions. This helps clients become more comfortable with wealth structures better-aligned to achieving their financial ambitions.
Experienced advisors have written extensively about how to approach conversations about goals.1 In this article, we describe how to apply the emotive conversations about goals to the practical process of building the best investment strategy for a client.
The Nature of Goals
We define investment goals as current preferences for future expenditures.2 As such, they reflect future liabilities, but they are not contractual liabilities in the sense a debt would be. These future liabilities have a number of interesting features worth exploring in greater detail:
- They represent what clients think they will want in the future, and they almost certainly will change over time.
- They are usually fuzzy and imprecise both in magnitude and timing.
- They have varying degrees of importance and priority.
- They have varying degrees of certainty with regard to what clients think they will want in the future.
- They are often highly contingent on what happens in the future, and in particular on the client’s future realized portfolio value.
Consider a newly married couple who plan to start a family. They might be saving for a larger home, thinking they want to move in about eight years, planning on having a couple years before their first child is born, then a couple more before their second child is born, and then moving to the bigger house about the time their older child starts school. Biology imposes lots of imprecision in the timing of this goal, and that’s not all. Imagine this family is blessed with twins in their second pregnancy. Rather than the two children they planned for so carefully, they now have three. Do they now need a still bigger house? A larger family car? Which is now a higher priority, the car or the home? Both are important, but does achieving both mean that the home needs to be a little further out of the city?
This is an example of a common type of problem we all face in our financial planning. Even when we have constructed a good plan, the world throws us curveballs. Understanding investment goals creates a dynamic, and potentially complex, system of desires, contingent actions, and priorities. We believe these difficulties lead many advisors to “jam-jar” approaches, where specific assets and cash flows are segregated in separate accounts aligned to the specific goal they will fund, or to avoid using goals at all. We strongly believe that goals are the key to investment objectives, even if they are difficult for financial advisors to build into investment models.
Goals help investors in a number of ways. Principally, they help investors to think constructively about what matters, and about the relative priorities of future aspirations, the most crucial of which may be many years in the future. Goals also motivate investors to plan and prepare. It would be foolish for advisors not to take advantage of this intuitive behavioral hook and risk leaving investors unprepared for foreseeable expenditures, or with a portfolio that fails to reflect their needs.
Jam-jar approaches are simplistic and inadequate, but defining the complete dynamic system of goals for any individual investor seems intractably complex. So what can advisors do about it?
We recommend the following five simple steps for working with a dynamic system of goals:
Consider only important and large goals, rather than long over-engineered lists of small and unimportant goals. This focuses the investment strategy on the investor’s key needs.
Capture the investor’s best guesses at the rough timing and magnitude of goals. Take time to emphasize goals’ flexibility and adaptability to changing circumstances.
Capture the priority, conditionality, and optionality around the timing and magnitude of each goal. For instance, if your client were planning a round-the-world trip in retirement, there likely would be flexibility in the timing and a willingness to delay the trip to save a bit longer and make it truly memorable. However, if that trip were to celebrate a milestone wedding anniversary it might make sense to not delay, to rather accept the likelihood of spending less on the holiday to secure the timing.
Emphasize the overall system of goals. The overarching need is to have enough money to spend when you want to for all of the goals in the system. This means avoiding organizing assets into accounts for specific goals or jam jars. This allows money to flow to the highest-priority goals at all times and avoid the inefficiencies of mental accounting present in jam-jar based planning (Thaler 1999).
Regularly review the system of goals to validate that these are still the most important things to your client. You often will find yourself reconfiguring the investment strategy to adapt to shifts in circumstances and preferences. Avoid aligning goals to separate jam jars or accounts, ensuring that the investor retains the financial and psychological flexibility to make dynamic reconfiguring easier and potentially less costly.
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Peter Brooks, PhD, is a behavioral finance specialist with Barclays. He earned a PhD in behavioral economics and an MSc in economics and econometrics, both from the University of Manchester. Contact him at [email protected].
Greg B. Davies, PhD, is head of behavioral and quantitative finance with Barclays. He earned an undergraduate degree from the University of Cape Town, and an MPhil in economics and a PhD in behavioral decision theory, both from Cambridge University. Contact him at [email protected] or follow him on Twitter at @GregBDavies.
Robert E. D. Smith. CFA®, is a behavioral finance specialist with Barclays. He earned a BEng in mechanical and manufacturing engineering from Warwick University. Contact him at [email protected].
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