Goals-Based Investing

Abstract

This article examines opportunities to improve wealth management by combining traditional finance theory with the observations of behavioral finance. Areas of focus include risk measurement, risk profiling, and methods for managing behavioral biases. In the area of risk measurement, the author stresses the importance of capturing investor preferences and goals and proposes several measures that are consistent with this objective. The author also critiques common risk profiling techniques, advocating separate risk tolerance estimates for separate goals rather than an overall risk tolerance for each investor, noting that the total portfolio framework of traditional finance is inconsistent with investors' tendencies towards mental accounting. A better result may be achieved by linking individual strategies to a specific goal or goals. The author describes a process for implementing his recommendations through examples, considering the challenges of investing to meet current lifestyle expenses and investing for a fixed planning horizon. The article closes with a call to align investment strategy development with common investor goals, arguing that this will promote consistency between the investment principles of the practitioner and the perspective of the individual investor.