How Sub-Optimal—If at All—Is Goal-Based Asset Allocation?

Abstract

Following the success enjoyed by goal-based allocation over the last several years, the author investigates what the focus away from traditional finance and toward behavioral finance may be costing, if anything, in terms of traditional investment efficiency. The author starts with a review of the modern portfolio theory framework and offers a hypothesis as to how the demonstrated inability of individuals to stick to a single optimal portfolio might be interpreted. He then goes on to review the behavioral solution of a hypothetical case study and compares the outcome with a traditional optimization. His analysis suggests that, once goal based allocation is re-formulated to allow some focus on the total portfolio trade-off between risk and return, the cost in terms of theoretical sub-optimality may be viewed as trivial. He does however concede that this experiment is unlikely to close the debate between the two branches of finance, as the analysis allows each side to claim some form of victory.