We all have goals. Sometimes those goals are financial.

Of course, many of our goals have little or nothing at all to do with finances, like respect from peers, raising children, being good people, or having a sense of purpose and accomplishment. Often, those goals are more important to us than our financial goals. They certainly occupy a larger percentage of our psychological capacity, day‐to‐day. Sometimes, we have goals we would like to achieve at some future date that could actually be accomplished using resources laid aside today. For those goals, some interaction with the ecosystem of financial institutions, markets, regulations, taxes, and people is warranted. When real people with real goals interact with this financial ecosystem, it is important that they have a reasonably effective map lest they find themselves wandering through the jungle that finance can so often be. This book is about using that ecosystem to accomplish financial goals—it is a better map (hopefully!).

But, to really understand how and why goals‐based investing is different, we must first understand goals‐based investors—that is, those real people who have real things they want to achieve in their very real lives. People do not enter this jungle for the fun of it, at least not usually. People enter this jungle hoping to come out the other side better off—to improve their lives and secure their future.

And it is here that traditional financial and economic theory has failed to provide even a reasonable map. I recently peer‐reviewed a scholarly paper whose lead author was an academic I greatly respect. The paper claimed to be operating in a goals‐based paradigm; that is to say, it was analyzing techniques that could be potentially used by goals‐based investors. Yet, despite the claim, the paper carried the very common academic assumption that an investor could use unlimited and costless short‐selling and leverage in an investment portfolio! I know of no real person who can borrow money in a portfolio and sell securities short without cost or limit. What an absurd assumption! Still, this assumption persists as the default for academics—largely because one must operate under the preferred paradigm of peer‐reviewers, though it also simplifies the math considerably. Yet, this kind of silliness also generates a map for investors that is so inaccurate as to be entirely useless to real people interacting with real‐world markets.

Building a proper map means we must first understand the people who are to use the map.

So, who are goals‐based investors? A goals‐based investor is, broadly speaking, any person or institution who has (a) specific funding requirements within (b) specified periods of time, and (c) some amount of wealth to dedicate to those objectives. Goals‐based investors are your co‐workers, your parents, aunts and uncles, friends, and your church. You are a goals‐based investor.

Goals‐based portfolio theory, then, is concerned with how to build an investment portfolio that delivers the maximum probability of attaining these real goals, given those inputs. If markets behaved as well as they do in theory (that is, if market returns were Gaussian), then most of those constraints would not matter. However, we know that markets are not so well‐behaved, so these constraints do matter—and matter quite a bit! This fact was realized decades ago, and even Paul Samuelson (the first recipient of the Nobel Prize in Economics) acknowledged that higher moments of return distributions (skew and kurtosis) matter to investors.¹ Mistimed drawdowns, as we all know intuitively, can destroy our ability to accomplish our objectives.

There are other important considerations. I know of no one who can leverage a portfolio without cost and without bound. Similarly, short‐selling is always limited in the real world—and not just by cost, but also by account type, regulation, and good, old‐fashioned prudence. In contrast with traditional theory, goals‐based investors are typically assumed to have no ability (or at least almost no ability) to short‐sell and leverage a portfolio. Additionally, since markets are not well behaved and a mistimed market drawdown can completely wreck a financial plan, goals‐based investors tend to be much more accepting of heuristics that can help protect a portfolio from the destruction that markets can bring upon the unsuspecting investor. And, as we shall see, this is not because investors do not like losses in the abstract; it is because goals‐based investors intuitively understand that portfolio losses lower their probability of goal achievement. Losses generate less wealth and less time to regain those losses, and markets can only provide so much upside in a subsequent recovery.

Jean Brunel, the father of goals‐based investing, enumerated another important distinction that is relevant here. When interacting with markets—whether public or private—very, very few individuals or institutions can be said to be price‐setters; we must generally be content to be price‐takers. And that distinction is important: price‐setters have the luxury of conforming markets to their own need, to meet their own objectives. The rest of us, by contrast, must be content to take prices, to approach markets as they are and not as we wish they would be. This distinction is important, but is also not immediately obvious.

Another challenge for goals‐based investors resides in the attitudes of those who fashion the tools and solutions. While our models of the world are very important, they also carry a danger. Much of academic theory, and even many practitioners, view markets as the equation on the page: x goes into the equation and y reliably comes out. But the real world is very messy, and we must account for that messiness, somehow. Goals‐based practitioners, then, must view the equation as only an approximation of markets: x goes into the equation and maybe y comes out, but z, m, and q might happen, too, so we should be prepared! Markets are not the equation, and they certainly are not reliable in any real sense of the word. We, as goals‐based investors and practitioners, must approach markets with a healthy respect. They can do much good, but they can also do much damage.

To put it as simply as possible: goals‐based portfolio theory is about using financial markets to achieve human goals, given real‐world constraints. Markets as they actually are is a real‐world constraint. As we will see, goals‐based investing is, in practice, not so simple. Unfortunately, real people and real‐world constraints make the portfolio management problem more complex, not less, and we have to leave behind many of the tools with which we are comfortable. But, were I lost in the jungle, I would much prefer a map maker who erred on the side of too much detail, rather than too little.

A full understanding of goals‐based investing begins with an understanding of the goals‐based investor. More than any other point made in this book, I want to stress this one: every investor is different. If you, practitioner, are to do your job correctly, you absolutely must begin with a thorough understanding of your investor. We cannot treat each investor like all the rest. Each investor has her own panoply of goals, her own tax situation, her own career, her own levels of wealth. Each investor has her own moral constraints.

Traditionally, our business has focused on the investment aspect of our role, to the exclusion of pretty much all else. I recall how I was trained on financial planning early in my career. Rather than central to the process, financial plans were viewed as a sales tool. “Whoever owns the plan owns the client,” “Use the planning process to uncover more assets,” and “Plan for what they need, but close with what they want,” were all common phrases. Talk about cynicism!

To be fair, this is how the business of wealth management saw the value they added: investing financial assets, not building and executing holistic financial plans. How could it be any different? In the end, the final investment decision was made by giving clients a risk‐tolerance questionnaire, and the portfolio managed by some far‐off investment committee. Risk tolerance is the only human input into the traditional portfolio optimization equation, anyway, and we cannot forget that it is a metric that regulators obsess over. Financial planning, though intuitively obvious, was superfluous in practice because the theory upon which portfolio theory was based made it superfluous.

This mistake in theory has been the foundation upon which wealth management was built. Wealth management firms tend to focus on the “big world,” the world of markets and interest rates, politics, corporate cashflows, GPD growth, and so on. Firms, then, must differentiate themselves with different views of markets. Where some focus on value investing, others focus on a macro approach, others tend toward growth investing, and still others have an algorithm that was hewn in the fires of Mt. Quant by elves, each bearing the magic imparted by five PhDs.

Of course, this approach is woefully insufficient. Clients do not really care about differences in market views; they care about achieving their goals. Not to mention, clients are almost certainly unqualified to assess those differences, anyway (I am not sure that I am qualified). The business of wealth management, if it is to survive, must be about helping clients actually achieve their goals. Despite my apparent cynicism, I do believe that markets views are very important (like all of you, I have my own cherished view). Better market views do yield better outcomes. I simply want to stress that market views are not the beginning and end of what we do. Rather, goals‐based investing sits at the intersection of the “big world”—the world of markets, interest rates, politics, earnings, P/E ratios, etc.—and your world—the world of your goals, your career, kids, taxes, moral constraints, and so on (as Figure I.1 illustrates). We cannot, should not, do our jobs without a proper understanding of both.

This means, of course, we must have a framework for interacting and talking with clients about what makes them tick. More knowledge is better. Much of the value a good practitioner can add is from a deep connection and knowledge of her client's life. For example, I worked with a couple for many years before it came out that they were deeply concerned that their second child was a spendthrift. We wound up discussing how they might bequeath their assets such that their child could enjoy it, but not squander it. Had I not enjoyed the rapport and familiarity with them that I did, this concern might never have been addressed and the problem would have been left unsolved.

While more knowledge is better, we cannot be expected to only do business with our closest friends. At a minimum, then, we must understand:

• Financial goals, which are defined as
  • Future funding requirements
  • Time horizons
  • Their relative importance
  • Current wealth
• Our client's tax situation
• Any ethical constraints or mandates
• Our client's human capital
• Asset location (and potential restrictions thereto)
• Any other relevant constraints on the investment process

With these minimum variables in hand, we can do our work: interfacing our market view with what the client needs done.²

Note how critical the financial planning process is here. Clients do not typically show up with all of these variables in hand. Clients may well know they want to retire in 23 years, but they are unlikely to know exactly how much they will need. Clients may know they would like to buy a vacation home in seven years, but they are unlikely to know exactly how much probability of attaining their retirement objective they are willing to give up to make that happen. Even institutions deal with an ambiguity that practitioners can help clarify. Many institutions want to incorporate impact investing or ESG constraints, for example, but have no idea how much they value that objective relative to their others. It is the practitioner's job to engage her client in conversation, to apply some structure to answering questions like “How much do I need to retire?” or “How much return are you willing to give up to incorporate an ESG constraint?” In goals‐based portfolio theory, financial planning is not a sales tool; it is foundational to the whole of portfolio management!

A full treatment of the financial planning process is beyond the scope of this book. There are numerous resources available to practitioners—many of them considerably better than I could ever hope to write. Thus, I will not dive any deeper into that topic here. However, I do hope it is clear that financial planning is the first step, and all else flows from first understanding our client. In subsequent chapters we will see just how important this step is. Unlike traditional portfolio theory, goals‐based portfolio theory is chock full of human inputs. The better we understand those inputs, the better our solutions can be.

If it is not clear by now, let me be very explicit: This is not a book about market philosophy. This is not a book about how to outperform the S&P 500, how to build the next algorithm, or how to pick triple‐bagger stocks. In fact, I have actively tried to avoid talking about my personal philosophy of markets. For one, I do not feel particularly qualified to do so—I have read plenty of books by practitioners who do it considerably better than I could (though I do have my own philosophy of markets, of course). More importantly, I want to stress that any philosophy of markets can fit within a goals‐based framework. Convertible arbitrage, long/short options strategies, value investing, or buy‐and‐hold investing can all fit within the goals‐based framework. This book is about organizing your market philosophy into a goals‐based framework.

My motivation to write this book is twofold. First, I find it immensely rewarding to help individuals accomplish their financial goals. I have yet to meet someone who has a crass “I just want to get rich” attitude. The folks I have had the joy of serving have had real things they want to achieve in their lives, like sending their children to college, or funding philanthropic endeavors, or operating and growing a business. Those goals prompt them to save and invest. To be a guide through the jungle of finance, and helping those folks out the other side, is wonderfully meaningful to me. After more than a decade and a half searching, I deeply believe that goals‐based portfolio theory is the best map through this jungle. It is the framework practitioners should be using in almost any circumstance.

Second—and this may be the most exciting aspect of goals‐based portfolio theory—is the world these tools have the potential to build. Yes, goals‐based portfolio theory generates portfolios that achieve financial goals more often than modern portfolio theory (or other tools in the literature). But it is also a tool to better understand people—a tool to better understand what it is they want, what they are willing to trade off to get it, and then to bring those desires to reality. As the industry begins to build and deliver the tools individuals need to fully express themselves in financial markets, then financial markets will better represent our society as a whole. Markets, in a world where people can express themselves through their investments more effectively, become considerably more human. This could be capitalism's greatest moment. This could be a time when we can look at financial markets, not as separate and distinct from our society, governed by rules and ethics of their own, but as a genuine mirror to our society. We may not always like what we see in the mirror, but we might finally agree that financial markets are an accurate reflection, nonetheless. This can only happen, however, if we as an industry do the necessary work to bring it about. What's more, I also believe it is how we continue to earn our fees. Capitalism works when value is exchanged for value. So much of our industry has become rent seeking, offering no real value other than clever marketing gimmicks. It is high time we start delivering real value.

This book is written to the searcher, to the sophisticated practitioner who is genuinely looking for the best way to serve her clients. There is plenty here for an academic, as well, but it is not my purpose to create an abstract document that is debated in the academy with no application to the real world. That said, I did allow myself one chapter to wax philosophical. For readers uninterested in how goals‐based utility theory affects the broader conversation around behavioral and normative economics, Chapter 13 can be skipped with no real loss of narrative (I am clear about that point in the introduction to the chapter). I do not want to downplay my excitement about that potential bridge between the two branches of economics, but I also recognize that it is not readily applicable nor interesting to many practitioners. For those who so choose to go down that rabbit hole with me, I am delighted with your interest!

Other than that chapter, I would recommend reading the book from beginning to end. Each chapter builds on the previous. Since I find it easier to understand a concept if I understand its history, the narrative of its origin, I open with the story of the ideas that coalesced into goals‐based portfolio theory. From there, I build out the foundation of the theory, and spend some time comparing it to the standard approach of modern portfolio theory. As we shall see, they are quite similar in some regards, but starkly different in others. Because the theoretical model carries some unique challenges in its implementation, we will explore some computational and practical solutions to these problems (though I do not claim they are the best solutions; they are simply my best effort).

The next few chapters build out the other points of goals‐based investing, namely the “real‐world constraints” part. I start by detailing a method for allocating wealth across multiple periods. While this seems superfluous, it is a common approach in the industry: A portfolio manager often has a multiperiod view, but most optimizers only span the coming period. Having a goals‐native, multiperiod optimizer can add considerable value (assuming our capital market assumptions are reasonably accurate, of course). From there I explore how goals‐based investors should view capital markets, generally, and I extend that discussion to how we might think of portfolio risk control, especially hedging. I find that investors should be willing to pay different costs to hedge a portfolio, and those costs are a function of an investor's goal variables. Derivative pricing is as dependent on the individual and her goal as it is on the portfolio manager's view of markets.

On a preliminary basis, I analyze how practitioners might view insurance through a goals‐based lens. There is no shortage of clever insurance marketing schemes, and there is a critical shortage of research on the role of insurance in goals‐based portfolios. It is clear, however, that insurance has a role in such portfolios—it is beneficial to goals‐based investors to spend resources to offset various kinds of risks—and I hope this chapter offers both an approach for approaching the problem as well as a signpost for directing future research.

Building on the concepts of allocating wealth across goals, I next explore how goals‐based portfolio theory informs impact investing. Impact, ethical, and ESG investing is very personal—each investor has a different view of what they want to do, the restraints they want to incorporate, and the impact they wish to leave. Thus, it is an excellent foil to demonstrate how the goals‐based framework might be applied when goals compete for a limited pool of resources.

I take up taxes and rebalancing next. To me, taxes and rebalancing sounds like a boring chapter. Unfortunately, it is where the rubber meets the road. Taxes, like everything else in goals‐based investing, is individualized, and, as we shall see, so is rebalancing. In that vein, we will also spend some time discussing the current state of client reporting and how the goals‐based framework might inform the presentation and ongoing monitoring of investment portfolios. I also explore how portfolio managers might better align their performance metrics with the goals‐based framework. As a first pass, I present two potential metrics that could better represent the value‐add of a portfolio manager to a client than our existing stable of portfolio measurement metrics. I then present a fragility analysis of goals‐based inputs. No matter how meticulous our forecasting efforts, we know that we are wrong to some degree. What amount of wrongness for which variables should keep us up at night? Given our limited man‐hours, where should we spend the majority of our time and skill?

No goals‐based discussion would be complete without a discussion of the human risks involved in private wealth management. While other authors have focused ad nauseum on cognitive biases as a source of risk, the purpose of my chapter on the subject is to identify the major nonfinancial risks present for the very wealthy. Those risks tend to be much more difficult to identify and are only tangentially related to the wide range of behavioral biases documented in the literature. Indeed, in my experience, managing financial risk is the easy part. Managing the human risks is considerably harder. Sadly, human risks are also the greatest threat to long‐term wealth building and maintenance.

The final three chapters are experimental, and certainly more academic. An interesting outcome of goals‐based portfolio theory is that it is, at times, perfectly rational to gamble. We don't call it gambling, of course—that would be too crude. In economic parlance, we would say that it is rational for individuals to be variance‐affine or variance‐seeking, as opposed to being always and everywhere variance‐averse (I don't say “risk averse” because goals‐based portfolio theory does not define risk as variance). This leaves practitioners with the question: How do we prudently manage a portfolio that is designed to maximize volatility, rather than minimize it? I do not claim any final answers here, hence the experimental nature of the chapter. Nonetheless, the conversation needs to be opened for practitioners, researchers, and even regulators, and my hope is that smarter people than me will take up the torch.

We then proceed to the more theoretical chapter, probably most interesting to academics. This is a project that excites me greatly. It is my belief that goals‐based portfolio theory, by better modeling what it is individuals are actually trying to do in the world, might provide a bridge between normative economics (what we think of as traditional, rational economics) and behavioral economics. This chapter is my attempt at putting this particular stake in the ground. Again, I claim no final answers, only interesting preliminary outcomes of the theory. I am along for the ride, wherever those discussions go in the future.

To round out the meat of our discussion, I spend some time ruminating on what the future of wealth management and investment management might look like, especially if goals‐based investing is more widely adopted. I find that the term goals‐based investing has become quite popular, but it appears to be little more than marketing for many firms. Here is my take on how firms might implement the ideas at scale, and, by delivering more value to their clients, earn more revenue in the coming decades. I close with some thoughts, a recap of everything discussed, and some resources interested readers might visit for a deeper dive into the various subjects.

Finally, I would like to have a personal word with my fellow practitioners. I admit to carrying a certain amount of imposter syndrome writing a book such as this. After growing up in a small town in central Texas, I pursued an undergraduate degree in music. Other than my CFA charter, I have no formal training in finance or economics whatsoever—I am a country boy with a music degree. The year 2008 was intellectually formative for me, occurring within the first year of my entrée into wealth management, and I have spent the subsequent years testing the common advice that I parroted. This intellectual quest ultimately led me here, to goals‐based portfolio theory, a practitioner‐oriented theory that cuts out much of the mumbo‐jumbo of academia and focuses on results. Needless to say, I felt that I had found my people. That said, it is entirely possible that I have “outkicked my coverage” and have gotten some (if not all) of this wrong. If that is so, I beg your forgiveness and humbly request that you publish some rebuttals—I do not want to hold nor advocate for incorrect views!

Given my background, I have a general disdain for discussions that are obviously more technical than they need to be. I have tried, as hard as possible, to present only the necessary and relevant bits, especially in areas that are particularly quantitative. I also have a deep disdain for matrix algebra. I typically roll my eyes when I see it presented in papers and books. Everywhere possible, I have tried to present the quantitative ideas in a way that a typical practitioner can decipher (read as: not in that form). That said, there are a few points where it simply could not be avoided. I ask your forgiveness and patience as you muscle through it (I had to muscle through when writing it!).

As a practitioner myself, I know the value of your time and attention. You have thousands of things pulling you in hundreds of directions. That you choose to spend your time with me and these ideas is a genuine honor. Thank you. I also want to be respectful of your time. This is not a book where I say something only to say it again in a different way and again in yet another. No. I try my best to communicate the ideas as concisely as possible, and when the idea has run its course, I will stop talking. Your time is too valuable for anything else. And since I tend to learn best through demonstration, I have included a few code examples for some of the more intricate topics for folks who would like to see it in action. All references to the book supplement can be found on the companion website: www.franklinparker.com/gbpt‐book/

Clearly, these ideas are fairly new, and some are controversial, even to me. For those of us steeped in traditional portfolio theory, there are aspects of goals‐based portfolio theory that will seem blasphemous. New and controversial ideas deserve extra scrutiny, and blasphemy even more so. Part of the purpose of this book is to open a wider due diligence on some ideas. I expect pushback, but I ask that we all keep open minds. More importantly, I expect that you will tell me where I am wrong. I have no desire to hold an idea that is incorrect, impractical, or even harmful to the people I have the privilege to serve. So, I humbly ask my fellow practitioners and researchers to point out my errors so that we may all learn and, through the ongoing conversation, grow this wonderful body of knowledge together.

With that, let us proceed.