Goals-Based Portfolio Theory

CHAPTER 13As a Bridge Between Normative and Behavioral Finance

“We build too many walls and not enough bridges.”

—Isaac Newton

Of all the tools goals‐based portfolio theory adds to the practitioner's toolbox, I find myself most excited about what it may do for economic theory more broadly. Today, economic theory is split into two camps. There are the normative economists who focus on how we should behave. Then there are the behavioral economists who focus on how we actually behave. To date, each has a legitimate critique of the other. The normative economists acknowledge that people often violate rational rules of behavior, but they continue to insist that the rational course is the one prescribed by traditional theory. The behaviorists acknowledge that normative theory may well be rational, but it certainly isn't practical, nor is it often reasonable. Behavioral insights not only reveal how we actually behave, but they are a better predictor of the actions of people in the aggregate.

Goals‐based portfolio theory offers another lens through which we can view the apparent dichotomy of behavior and rationality. Indeed, I am convinced that people are not as irrational as we have so far believed. Rather, if we simply better understand their motivations, if we better understand what goals people are attempting to accomplish in the real world, then many of the normative‐behavioral paradoxes melt away. In this way, goals‐based portfolio theory offers a bridge between traditional ...