Repercussions for wealth managers following the post-September 2008 financial crisis have included issues of trust, communication and scrutiny. Add the growing popularity of goals-based planning for wealthy clients to the list.

Repercussions for wealth managers following the post-September 2008 financial crisis have included issues of trust, communication and scrutiny.

Add the growing popularity of goals-based planning for wealthy clients to the list.

The concept, popularized by Ashvin Chhabra, chief investment officer at the Institute for Advanced Study in Princeton, NJ, stresses putting the lifestyle goals - and attendant risks - of a client ahead of the traditional principles of modern portfolio theory in the asset allocation process.

“An individual’s risk tolerance can be very different from what the market provides on the average,” according to Dr Chhabra, who holds a PhD in applied physics from Yale University and was previously head of wealth management strategies and analytics at Merrill Lynch.

“When trying to plan for an individual, what the market is doing is of secondary importance,” Dr Chhabra said. “It’s more important to meet the essential cash flow needs with very high probability. The question shouldn’t be ‘How do I beat the market or even achieve market returns?’ It really should be ‘How do I achieve my goals objectively in a way that I’m comfortable?’"

After working on the concept for a decade, Dr Chhabra, along with co-authors Ravindra Koneru and Lex Zaharoff, wrote “Creating a Goal-Based Wealth Allocation Process” in the winter 2008 issue of The Journal of Wealth Management, right on the heels of the market meltdown. The timing was fortuitous, and the article attracted wide attention.

Interest in goals-based planning increased “exponentially,” Dr Chhabra said, especially among financial advisors and clients. Larger Wall Street firms have been less enthusiastic, but are “slowly embracing” the approach, he said.

Some critics have rejected the planning style outright, arguing that downplaying sophisticated asset-allocation strategies inevitably leads to “sub-optimal” market returns for clients.

Wealth managers on board

Nonetheless, a growing number of leading wealth management and multi-family office firms are becoming fervent proponents of goals-based planning.

“This is absolutely where people want to be,” said David Lamere, chief executive of BNY Mellon Wealth Management. “We are strong advocates of a purpose-driven plan. It’s a sea-change in the way things are being done,” he said.

In fact, one of the lessons wealth managers learned after September 2008 was that “we weren’t speaking the same language clients were speaking about risk,” said Steven Reiff, national director of investment solutions and advice for BNY Mellon Wealth Management.

“Clients don’t understand standard deviation,” Mr Reiff said. “They define risk in terms of not being able to meet objectives such as being able to retire or transferring wealth to their children.”

The old asset allocation model focused on one portfolio that met a client’s “aggregate needs,” said Chris Sheldon, BNY Mellon Wealth Management’s director of investment strategy.

The firm’s new approach segments wealth “strictly for lifestyle,” Mr Reiff said. For example, he said, a “safety portfolio” would include greater amounts of fixed income, TIPs, commodities and “very small portions of equity.”

The “wealth-transfer portfolio” would likely contain illiquid assets such as hedge funds, private equity and distressed securities as well as international and emerging market stocks.

Having separate portfolios, said Mr Sheldon, “greatly reduces the temptation [for the client] to act on impulse.”

Three ‘buckets’ of risk

Boston-based Silver Bridge Advisors is using a similar methodology, using Dr Chhabra’s “three-bucket” approach to risk.

The first bucket, or portfolio for the client, is labeled “personal risk” and emphasizes safety and preservation of lifestyle, cash flow and principal protection.

“This bucket is designed to minimize downside risks and will have assets the clients know will be there to pay bills for short-term goals,” said Dune Thorne, a managing director for Silver Bridge.

“Market risk,” Dr Chhabra’s second bucket, is designed to maintain a client’s lifestyle by “balancing risk and return to attain market-level performance from a broadly diversified portfolio.”

The third bucket, called “aspirational risk,” attempts to outperform the market by taking “measured risk.”

This portfolio is likely to include concentrated, illiquid positions such as a family business or art holdings, Ms Thorne said.

“A client may have a strong emotional attachment to these holding,” she said,” and they may make no rational sense. They may see significant growth, but they also have to be prepared to lose everything.”

The challenge for wealth managers using this approach is working with families to define risk and liquidity, she explained.

“After a period of volatility like we just saw, families may still have significant wealth, and they may have a significant balance sheet, but that doesn’t mean they can pay big bills like college,” Ms Dune said.

Wealthy families are responding positively to the goals-based planning approach, said Kristi Kuechler, president of the Institute for Private Investors, noting that Dr. Chhabra has spoken at IPI conferences.

“Investors find it very intuitive to construct portfolios around a true understanding of their goals and liabilities,” Ms Kuechler said. “Families are seeing their portfolios constructed the same way as an institution’s and I think the insight of [of Dr Chhabra’s approach] is that a portfolio doesn’t need to be optimized to an algorithm, but instead can be optimized to the needs and goals of the individual family.”

Kahneman’s influence

The roots of goals-based planning can be traced to the work of Dr Daniel Kahneman, a psychologist and Princeton University professor who won the Nobel Prize in 2002 for his groundbreaking work on behavioral finance, said Charles Stucke, chief investment officer for Chicago-based Guggenheim Investment Advisors.

In the late 1970s, the Harry F Guggenheim Foundation funded Dr Kahneman’s research in the field, which led to “Prospect Theory,” a seminal paper he wrote on judgment and decision-making with colleague Amos Tversky.

Dr. Kahneman questioned the assumptions of risk in human decision-making under conditions of uncertainty that were being used by economists and financial professionals in concepts such as the Sharpe Ratio and volatility and value-at-risk models.

“The problem with those approaches is that volatility doesn’t speak to risks that people care about directly,” Mr Stucke said. “Volatility is a two-sided risk measure. Risk counts as much on the downside as the upside.”

Risk budgets

Dr Kahneman, who is now a senior advisor to Guggenheim, wrote that individuals have their own “risk budget.” People simultaneously have “loss aversion,” and don’t want to lose money, but also “gain regret,” which is how they feel when others make money and they don’t.

To find a solution for clients for those competing concepts, Guggenheim incorporated economist Richard Thaler’s notion of an individual’s concept of “mental accounting,” Mr Stucke said.

“That idea says that people tend to frame the way they think about organizing wealth by separate mental accounts or boxes, one conservative and one bold,” Mr Stucke said.

In 2005, Guggenheim began offering clients two distinct portfolios:  one conservative, to deal with loss aversion and one bold, to address gain regret.

The approach, Mr Stucke said, allows Guggenheim to help customize portfolios more effectively for clients and gives clients “a stronger ability to mark and measure us without excuse.”

Enthusiasm for this goals-based approach has taken off since September 2008, Mr. Stucke said. "What people believed were conservative portfolios had a lot more risk than they expected,” he said.

Mr. Stucke and other wealth management executives expect momentum for goals-based planning to continue.

Not only do clients like the approach, but it’s also good for business, Silver Bridge’s Ms Dune said.

“We believe it’s a differentiator for us,” she explained. “It builds stronger, deeper relationships with clients. We’re not talking about their money in a theoretical, institutional framework. We’re talking about it in a way that is tied to their goals.”