Goals-Based Portfolio Theory

CHAPTER 3Allocating Wealth Across Goals and Across Investments

“If you want to live a happy life, tie it to a goal.

Not to people or things.”

—Albert Einstein

I admit it seems odd to write a whole book on a theory that can be expressed in a page and a half. Yet, though the presentation of the theory is relatively simple, it is not so simple to put into practice! Most notably, the optimal allocation of wealth to a particular goal depends on the allocation to investments within that goal, and the optimal allocation of investments within a goal also depends on the allocation of wealth to that goal. This recursivity, coupled with the unfamiliar optimization approach, make it worthwhile to spend time solving these problems from the perspective of a practitioner. There are other practical problems, like eliciting the relative goal values from clients. The model takes these points as a given, but they are, in practice, not so straightforward to solicit. This discussion will be about how a practitioner might go about solving these problems, though I will not claim a monopoly on these solutions—others could likely do better! Even so, we shall press ahead, and let us start with the simpler problem first.

How can we ascertain the relative value of goals in an investor's goalsspace? How can we know how much an individual values retirement relative to sending her kids to college, for example, or how much she values funding an estate goal versus buying a vacation home? In the previous ...