The 2008 financial crisis cut a wide swath of destruction from Wall Street to Main Street. But few groups were as poorly prepared to withstand portfolio losses as individual investors.
Among the main reasons: Asset classes became overly correlated and investors didn't have enough exposure to alternative strategies. Yet there was another culprit-the disconnect between investment portfolios and individual goals.
Most retail investors have allocated their portfolios according to their supposed risk tolerance. My contention is that it makes far more sense for clients to invest according to their financial capacity to withstand risk.
Financial advisors who want to thrive going forward should consider building client retirement portfolios capable of funding each investor's essential retirement goals, regardless of how the markets behave at any given time. This is fundamentally different from other retirement-oriented approaches, and it will require a deep rethink of both what the advisor's role is and how to fulfill it.
A FLAWED MODEL
Cash-flow investing is among the most widely used investment advice models, and it is one that might be easily confused with goal-based investing at first glance. As with other traditional models, I'd argue that cash-flow investing fails to address fully all the facets of an individual investor's unique financial life, and therefore cannot effectively lead to suitable or successful portfolios for retirement.
For a portfolio constructed using the cash-flow approach, investment contributions are limited to money from a client's taxable and tax-deferred accounts. The investment plan typically doesn't encompass a client's complete financial picture, including the value of his or her home.
Also, the investment framework for a cash-flow portfolio is based around a client's risk tolerance. Most financial advisors determine a client's risk tolerance through questionnaires, based on an age-determined time horizon, in hopes of objectively measuring the amount of investment risk a client can psychologically and emotionally bear given his or her targeted retirement date.
But this approach doesn't address the markedly different definitions of risk that advisors and clients hold. Advisors tend to think of risk as a function of market volatility-a measure of performance as a return against an investment benchmark-independent of progress against client goals.
Clients, on the other hand, usually think of risk in terms of portfolio losses that might prevent them from achieving tangible goals, such as a secure retirement or paying for their children's college education. When a household has limited financial capacity to bear risk, regardless of its psychological tolerance for it, the cash-flow and other traditional approaches of providing advice based on risk potentially lead to significant losses.
The result is that cash-flow and other traditional investing models fail to connect investment plans with an investor's funding needs. Financial advisors are unable to combine their financial planning and investment management services in an efficient way that reflects the personal situation of every client.
This difficulty creates an often disjointed advice process that may increase risks for investors and fail to help them reach their long-term financial goals. What's needed is a deeper analysis of the client's total household financial picture as the driver of investment advice, more so than other factors such as age, time horizon or a psychological assessment of risk.
A GOAL-DRIVEN APPROACH
Enter goal-driven investing-a more comprehensive approach to investing for retirement that enables advisors to develop a strategy based on a client's actual household financial picture. This approach deals with a broader variety of questions: When will I have enough money to retire? How much do I need to save in order to retire? What is the minimum level of money needed for retirement? How much extra is necessary for an affluent retirement? Can I afford other financial goals?
A key nuance is that with the goal-driven approach, an advisor breaks down an investor's objectives into priority classes. Saving for a certain standard of living in retirement shouldn't come at the expense of saving for a college education. However, saving enough to fund $15,000 in annual tuition at a state school is more essential than paying $50,000 a year for the pricey university.
Prioritizing goals this way allows for greater planning flexibility. Everything defined as essential should be immunized from an investment standpoint, whereas aspirational goals are subject to more uncertainty as to whether they can be achieved.
Goal-driven investing integrates financial planning and investment management into a single process. An advisor first identifies client goals and inventories client resources for investment, then sets a strategy optimized to most efficiently pay for the client's goals.
The resulting asset allocation recommendations reflect a client's risk capacity-as opposed to risk tolerance. This is measured as potential losses a client can withstand economically and still meet his or her personal goals.
The objective of goal-driven investing is to meet a client's minimum funding objectives regardless of market performance, ensuring that the client can achieve his or her essential retirement goals. The advisor begins by determining a client's household resources available to support future goals and liabilities; this data represents the client's household balance sheet.
The asset side contains both controllable and fixed assets. This includes employment income, Social Security payments, rent or capital gains from real property, interest from fixed investments and current income, and capital gains from managed investments.
On the liability side are the client's goals-future expenditures against their financial resources. These could include mortgage payments, college tuition and retirement living expenses.
Some of these may be unavoidable and fixed liabilities. Others may be obligations with lower payment priorities that the client could potentially postpone.
BALANCE SHEET MUST BALANCE
Under ideal circumstances, net resources should be positiveâ€”that is, the total cost of the householdâ€™s liabilities and goals should be less than the total resources that are available. This will enable the clientâ€™s household to meet its goals with a degree of certainty. At the very least, resources must balance against future costs and present liabilities.
Financial advisors then need to learn their client's specific goals for retirement. Goal-driven investing is more interested in helping a client meet specific goals, like owning a second home or buying a boat, than it is about beating arbitrary performance benchmarks.
The advisor and client also must prioritize these goals according to how essential they are to the client's overall retirement plan. Since the client provides his or her input about specific objectives, goal-driven investing leads to more personalized portfolios with a more balanced asset/liability match.
The household balance sheet structure sets the client-specific investment benchmark. The margin of safety of total resources over total commitments defines the household's capacity to bear risk in the investment portfolio.
Once the financial advisor determines risk capacity, he or she can develop a portfolio most likely to perform within the agreed-upon risk parameters. Money from the client's cash flows is invested along with other available household income so that investment resources generate sufficient income to meet essential goals.
This means that the overall risk of the portfolio is set so that its downside loss potential can't put the ability to meet the client's liabilities and essential goals in peril. If a 5% loss would impact the household's ability to meet essential goals, then the portfolio would need to be invested very conservatively.
Over time, a client's balance sheet and portfolio will both need to adapt as personal or family circumstances and market conditions change. Some of these changes, such as growing income from employment or rising equity in a family home, are largely evolutionary and can be fairly easy to predict. Individual investment plans need to set and stay within a "risk budget" that aligns a client's portfolio with his or her evolving goals as well as changing markets.
IMPLICATIONS FOR ADVISORS
Clients aren't the only ones to benefit from goal-driven investing. Financial advisors practicing this strategy can expect stronger relationships as a result of working with clients to determine their household resources, retirement goals and risk capacity. In addition, goal-driven investing makes a financial advisor stand out in a crowded advice marketplace overly focused on benchmark-based performance.
Better still, goal-driven investing gets clients more involved in their portfolios and keeps them involved. The more clients understand about the process, the more they can commit to an asset allocation target. This simplifies the advisor's responsibilities, enabling him or her to adjust a client's strategic allocation whenever the client undergoes important life changes.
Most important, goal-driven investing gets financial advisors and clients working on the same page as to what constitutes investment risk. An advisor needs to provide retirement advice that reflects a client's long-range goals-even if those goals sometimes change to reflect their financial situation.
In contrast, a cash-flow advisor typically offers "stay the course" advice that keeps a client's portfolio tied to various market benchmarks. This ignores the possibility that an investment associated with the portfolio might exceed the client's capacity to bear risk based on his or her desired goals.
Advisors who fail to alert their clients about this type of risk essentially put themselves on the hook for the greater level of financial stress that's sure to follow. The financial crisis of the past few years should remind advisors that while no one enjoys being a messenger of financial caution, doing nothing should never be an option.
Andrew Rudd is chairman and CEO of Advisor Software, a provider of wealth management solutions. He is the co-founder and former chairman and CEO of Barra, which was acquired by Morgan Stanley Capital International in 2004 and renamed MSCI Barra.