Financial wellbeing - the ultimate investment proposition

The best value advisers can add to clients is arguably guiding and coaching them to a state of financial wellbeing. This is achieved when clients feel secure in their financial position and feel they have the financial freedom to make choices about their current and future life. Private investors experience this state when the following four elements are present:

When the investment proposition of financial advisors addresses these four elements, they deliver the ultimate value of financial advice.

When it comes to financial wellbeing, the science of goals can play a significant role. Research shows that clients who experience progress towards the attainment of their financial and life goals tend to feel a sense of wellbeing. This is because goals provide clients with a future orientation, focus their activities, motivate their behaviour, and provide purpose and meaning to their lives.

When we as humans set and pursue goals, our brains produce a happy drug called dopamine. Dopamine acts as a motivator, creates a sensation of pleasure and helps us to maintain attention. All of these are emotions that advisors can use to guide clients to better investment behaviour.

When an advisor helps clients to explore, define and pursue meaningful life goals, they make the investment plan personal and provides them with context to interpret and evaluate information throughout the investment journey within the context of their life. This, in turn improves decision making because it allows the client to evaluate investment strategies, risk, and outcomes in the context of the goals’ importance, and the consequence of achieving or not achieving it will have on their life.

When a client’s investment plan is structured to incorporate goals in each of the four areas mentioned, the plan becomes a tool which forms the foundation for developing a sense of financial wellbeing. For example, an income goal can help a client feel in control of their finances and provides the peace of mind knowing that they can maintain their current standard of living. Having goals that address financial security, like clearly placing emergency funds in place, talk to the need for feeling safe. Setting goals for life events make clients feel that they can enjoy life, and articulating goals to address a client’s future life give them hope.

As mentioned, goals differ in terms of their importance and the consequence they have on the client’s life. The type of goal will influence an investor’s behaviour over the course of the investment journey and will determine whether they can stay the course when markets perform poorly. That is where goals-based investing can add value.

Different research papers by organisations like Dalbar and Morningstar have shown the impact that investor behaviour has on investment returns. The research showed that investor behaviour can detract between 1.5% to 3% per annum from investment returns.

Other research done by the CFA Institute and Vanguard shows that the advisor’s value, or as they call it “advisor gamma”, can be up to 3% per annum. More than 50% of this value can be attributed to improving a client’s decision making by managing their behaviour.

To add this value, advisors need an investment management approach that integrates how private investors think and act with traditional finance principles. Goals-based investing is a planning approach that helps advisors to manage their client’s financial behaviour better throughout the investment journey.

Goals-based investment planning is a holistic, client-centric approach that focuses on creating strategies to finance a client’s life goals rather than matching a product to a need. The client’s goals are identified, prioritised and specified in terms of needs, wants and aspirations that have meaning and significance to the client, instead of merely creating an investment plan with generic financial goals. It provides a framework for capital allocation and portfolio construction specific to each goal’s profile, to achieve a specific outcome at a predefined probability over a specific investment term.

Instead of constructing a single portfolio using funds from a specific CIS category or applying a bucket approach using time diversification, an investment portfolio is constructed for each goal based on the probability of the outcome, specific goal risk, and the behavioural profile of the goal type.

By framing the goal in terms of the client’s life and constructing a separate portfolio for each goal, the client has a context, which assists them in understanding why a specific strategy is suitable for the goal. It also creates multiple reference points that the client can use to monitor progress through the lens of the goal’s importance and their risk tolerance.

Goals-based investing differs from traditional investing in terms of how clients are profiled, risk is defined, portfolios are constructed, and performance is measured.

Client profiling

The traditional approach of investment planning profiles clients in terms of their financial circumstances and risk tolerance. A goals-based approach requires a more holistic approach which profiles clients in terms of financial circumstances, behavioural factors, and life plan. It requires a clear understanding of the client’s financial persona which includes their money history, money habits, money mindset, and their values (what is important to them).

Risk profiling is also different when following a goals-based approach. Instead of using a single risk profile for a client, a risk profile is developed for each goal by considering the risk tolerance, risk cognition, and goal specific risk capacity.

Defining risk

Instead of defining risk in mathematical terms like standard deviation or volatility, risk is defined as the probability of not achieving the goal and the risk of losing capital over the investment term.

Portfolio construction

Instead of constructing a single portfolio, a separate portfolio is constructed for each goal by considering the goal type, the range of outcomes, and the probability required.

Benchmarking

Many investment plans measure success compared to some relative benchmark like beating an index or category average. A goals-based approach creates absolute benchmarks for each goal. This ensures that multiple reference points is created and that each goal’s success is measured in terms of the required outcome, which is the end wealth needed to finance the client’s goal.