The concept behind goals-based construction is to build portfolios that target specific client goals rather than the usual approach of optimizing the portfolio Sharpe ratio – a statistical portfolio property that may or may not have any real meaning to the average investor.

For example, as Ashvin Chabbra, Jean Brunel, and others have suggested, a portfolio might be “bucketed” to meet specific investor objectives such as: Lifestyle maintenance ; market participation ; and aspirational wealth .

A different approach might be to present individual investments in the context of their specific purpose within the overall portfolio – which might be referred to as a “why” versus “what” approach:

1. Capital preservation and income,
2. Market exposure-based growth,
3. Diversifiers, and
4. High risk growth.

It is worth noting that the underlying tenets of Modern Portfolio Theory are not discarded when implementing goals-based portfolio construction. Risk, return, and diversification still matter, and the overall portfolio should still be optimized using traditional MPT inputs and outputs. The presentation of the portfolio, however, is designed to align with how investors actually think about their money .

Some practitioners of this approach advocate optimizing each sub-portfolio and then “rolling up” the sub-portfolios into an optimized overall portfolio. Others believe that is that the primary value of the exercise is optical – presenting the recommended portfolio in investor-centric ways – so optimizing at the overall portfolio level is sufficient, even if the corresponding sub-portfolios are not “optimized” on a stand-alone basis.

A quantitative variation on this theme is applying to individual investors the institutional investing concept of “Liability-Driven Investing”, or LDI. With institutional LDI, the future liabilities of the investor are forecasted and a portfolio is built that attempts to minimize the risk that the portfolio will not be able to meet its future funding obligations. Any surplus portfolio assets not required to “immunize” future liabilities can then be invested more aggressively to grow the overall portfolio value.

Some advisors to individual investor portfolios are now applying this concept. Future obligations or “liabilities” are forecasted and portfolios are then constructed to fund those liabilities, with any excess assets invested more aggressively for dynastic wealth or end-of-life charitable purposes.

So why is a goals-based approach increasing in popularity. Two primary reasons stand out – one practical and one behavioral. The practical reason is that technology has advanced to the point where it feasible to propose, build, manage, and report on portfolios in a goals-based manner. Since most investments represent specific asset classes , it is not a trivial exercise to transform and map them to specific investor objectives for proposal and reporting purposes. But several commercially available software tools now allow advisors to do just that, and more are on the way.

The behavioral reason is perhaps a little more cynical. We are in the seventh year of a central bank-fueled equity beta rally, where active management has generally underperformed and the traditional benefits of diversification have been nowhere to be found. In this market regime, advisors must evolve away from focusing on index-relative returns and toward new “benchmarks” – identifying and addressing specific client objectives. Even if that cynicism is true, however, the adoption of goals-based investing is a very positive trend in the HNW market place – it’s where we should have been all along.

Regardless of how it is applied, the underlying purpose of objectives-based portfolio construction is to build and present portfolios in the way that individual investors actually think about their money – which is that different buckets of money have different specific purposes.

The belief is that this approach helps investors understand better how they are invested and why, and helps to instill investor discipline, which is a critical component to long-term investment success.