Goals-Based Portfolio Theory

CHAPTER 1The Story of the Idea: How Goals‐Based Portfolio Theory Came to Be

“I’ve heard people compare knowledge of a topic to a tree. If you don’t fully get it, it’s like a tree in your head with no trunk— when you learn something new about the topic there’s nothing for it to hang onto, so it just falls away.”

—Tim Urban

When presented a choice between multiple possibilities, which one should you choose? This simple question has perplexed many a human being. Modern economics found its beginning with an attempt to answer this basic question. The wealthy class of Europe had quite a bit of time on their hands, and, as it turned out, they enjoyed gambling on games of chance. The Renaissance had shifted the traditional view of these games—rather than simply accept randomness, some of these aristocrats began to analyze the games mathematically in an attempt to understand their randomness. It was not through any pure mathematical interest, of course, but rather an attempt to gain an edge over their fellow gamblers and thereby collect more winnings!

The thinking of the time coalesced around a central idea: expected value theory. Expected value theory stated that a gambler should expect to collect winnings according to the summed product of the gains or losses and the probabilities of those outcomes (i.e. , where is the probability of gaining/losing , and is the index of possible ...