New clients of a financial adviser usually fill out a risk tolerance questionnaire. Chances are the tolerances are average, so they are given a balanced portfolio of half stocks and half bonds, diversified by region.
"It's like putting one foot in a bucket of freezing water and the other one in a bucket of boiling water," says Sam Sivarajan, head of Manulife Private Wealth and a proponent of goals-based investing.
In reality, people's risk tolerance varies depending on the financial goal or dream, Mr. Sivarajan says. "They may be aggressive on one goal and conservative on another."
Now imagine meeting an adviser or portfolio manager who, instead of poking and probing to gauge your risk tolerance, asks you about your goals and aspirations. Deep down inside you know you don't want to lose money, which is Goal No. 1. Goal No. 2, you want an income when you retire that will last for the rest of your life. And you don't want to be put through the ringer again like you were in 2008, and that's Goal No. 3.
With goals-based investing, advisers and managers design portfolios to meet specific goals rather than trying to earn the highest possible return or beat the market. Risk is defined as the probability of not achieving your goals, which is how people intuitively define risk, writes Jean L.P. Brunel in a 2012 paper published by the CFA Institute. Mr. Brunel is managing principal of Brunel Associates LLC and author of the 2015 book Goals-Based Wealth Management.
Financial advisers should talk to investors "not in terms of risk and return but in terms of dreams and nightmares," Mr. Brunel writes. "These are the goals they want to achieve with the greatest degree of intensity, and their failure to achieve them will be felt with the deepest pain."
This shift in thinking from beating the market to meeting goals resulted from two key events since modern portfolio theory took hold in the mid-20th century. The first was the 2008 financial panic, when investments all went down the drain at once. So much for diversification. The second was the low interest rates that ensued. So much for yield.
"For people who need volatility protection and want to rely less on the direction of the market, traditional portfolio theory is far less effective than it used to be," says Craig Machel, a portfolio manager at Richardson GMP in Toronto who specializes in alternative investments. "Simply hoping that markets will reward you for being there is a dangerous way to treat retirement savings."
When designing portfolios, advisers and portfolio managers need to draw on the widest range of assets and strategies, deciding which are most likely to help investors achieve each goal, Mr. Brunel writes. Goals-based or evolutionary portfolio theory, as it is sometimes called, taps the entire investment universe, active and passive, in search of stable returns. More stable returns mean a smoother ride for investors.
If a client needs money to live on, he or she needs investments that offer regular distributions. Investors' biggest nightmare is having to change their lifestyle, Mr. Brunel adds.
Mr. Machel puts investments into three buckets: yield, for people who need cash flow; defensive, to stabilize the portfolio; and long-term capital growth, ideally that outperforms the market.
Typically, the yield category will not include publicly traded securities but rather private lending and mortgage strategies as well as private real estate strategies, he says. The defensive category will include long-short equity and bond funds and merger arbitrage funds (also hedging strategies).
The long-term growth bucket is the one that most investors will be familiar with, Mr. Machel says. This will be the most volatile part of the portfolio.
At Manulife, Mr. Sivarajan and his team spend considerable time trying to understand what their high-net-worth clients want, going well beyond the customary questionnaire.
"What is the goal, how long before you need the money, how much will you need at the goal date, how much can you allocate to the goal today and how much can you contribute in the future," he says of the process. "We do that for each goal," coming up with a different asset mix for each bucket.
Then he looks at what rate of return the investor needs to achieve the goals. If it's not realistic, investors may have to spend less or retire later. "The benefit of our approach is I have that conversation right up front," he says.
Both portfolio managers have the same goal: To design portfolios for investors that outperform in rising markets and protect investors better in falling markets. So when markets tumble, as they inevitably will, investors following a goals-based approach will be less likely to panic.
"It helps stop clients from panicking and selling at the bottom," Mr. Machel says.
The ETF way
For a classic example of modern portfolio theory, investors need look no further than robo-advisers, computerized portfolio managers who use mainly exchange-traded funds. Granted, they are good, low-cost alternatives for retail investors who don't have million-dollar portfolios. Linked as they are to indexes, though, they could be hair-raising for investors in a market crash.
Larry Berman has a better way of designing portfolios using ETFs, calling his approach the "human portfolio," (rather than a robo-designed one). Mr. Berman is a portfolio manager and co-founder of ETF Capital Management in Toronto and he, too, believes the investing climate has changed so much that the old way of constructing portfolios is no longer effective.
As for robo-advisers, passive investing or tracking an index doesn't work well because investors' appetite for risk rises and falls with the market, leading them to behave the opposite of how they should, he adds. "You have to be an active investor," he says.
The vast array of ETFs today – some with hedging powers – makes tactical asset allocation simple. The key is understanding investors' behaviour and modifying it through education, he says. He also offers investment seminars.
"We build you a customized investment strategy designed to keep you in your personal comfort zone," the firm says on its website, "so you don't have to fight your emotions to get the investment results you need for the comfortable retirement you deserve." ETF Management deals mainly with high-net-worth investors – those with at least $750,000 of investable assets. Mr. Berman also manages what he calls a "sleep at night portfolio" for retail investors, the BMO Tactical Dividend ETF.