Goals-Based Portfolio Theory

CHAPTER 4Allocating Wealth Through Time

“…the present is short, the future is doubtful, the past is certain.”

—Seneca

I remember, after 2008, when I had finally cobbled together my “recession dashboard,” I excitedly put my capital market expectations into a typical mean‐variance optimizer. I expected to uncover some secret, that this optimizer would suddenly “see” what I saw—that a probable recession warrants a defensive portfolio posture. The output was extremely disappointing. Rather than suggest a defensive allocation of cash and bonds, as I may have expected, the optimizer had only slightly reduced holdings of stocks and increased holdings of gold. I did the same for my goals‐based optimizer (which maximized the probability of attaining a required return). The results there were even sillier. Again, rather than suggest a defensive allocation, the goals‐based optimizer suggested an all‐gold allocation. Sigh. What was I doing wrong?

Quite simply, it is not accurate to allocate wealth in the context of the coming period only. We intuitively understand this, which was the entire motivation for me to develop my own recession dashboard. Intuitively, we know that a defensive posture ahead of a potential market selloff gives us cash to buy when prices are lower, thereby pushing our wealth significantly closer to our goal when prices recover. In the face of a probable recession, for example, our market return expectations might be significantly lowered and variances significantly ...