We believe that goal-based advice is superior to any other form of investment advice as clients always have financial goals.

All clients have at least one goal in mind when they invest, even if they only want to increase their wealth or minimise losses. This type of investment advice requires a realistic risk framework, which enables accurate wealth projections and a superior user experience. Todays’ advisory processes rely mostly on outdated and single-period risk frameworks: take the example of Markowitz, a methodology from mid-last century and yet widely used in investment management and advisory. The standard assumption of this methodology is that returns are normally distributed and that the expected returns do not change over time.

While it is widely accepted and proven empirically that returns are not normally distributed, most wealth managers still use conventional single-period risk frameworks like Markowitz.

One proof that returns are not normally distributed is that capital markets have had higher losses than gains in the past: negative returns have been observed both in greater magnitude and with a higher probability compared to the ones implied by normally distributed returns (so-called ‘Fat’ Tails).

This mismatch results in a significant liability risk of the wealth manager: all investment portfolios derived from conventional risk frameworks consequently carry a higher downside risk than projected.

Additionally, conventional risk frameworks do not include the clients’ financial goals, savings or liabilities which are all needed for financial and wealth planning. Hence, a sound wealth development cannot be forecasted based on the clients’ financial goals. Further, key wealth parameters like inflation cannot be integrated into the wealth forecast, aggravating the above-outlined liability risk of the wealth manager.

To overcome this, wealth managers need a risk framework which is realistic and generates investment recommendations that best fit to the individual situation of the client. Therefore, a multi-period stochastic optimisation risk framework should be used: it simulates wealth development based on the clients’ financial goals accurately and mitigates the liability risk for the wealth manager.

With a multi-period risk framework, a goal-based advisory solution can also be significantly improved: the ideal goal-based advisory solution is responsive (reacting to changes instantly), holistic, individual, and includes the wealth manager’s specific market view. Some of that functionality is enabled by the multi-period risk framework:

a.    Goal-based and responsive

Most individuals have multiple financial goals, e.g. to close the pension gap and to finance their kids’ university. Such financial goals are equal to cash flows that occur over time. A professional goal-based solution allows for the simulation of multiple goals / cash flows simultaneously, both in nominal or inflation-adjusted terms. The wealth forecast then changes with every adjustment instantly. This is only possible with a multi-period risk framework.

b.    Holistic

It is indispensable to consider all assets of individual clients that may be used to achieve their financial goals. This includes assets held at third-parties and all non-bankable assets like private equity and real estate. Liabilities like credits, on the other hand, reduce the likelihood that clients achieve their financial goals and must be considered in the calculations as well.

c.    Individual

Individual clients have completely different goals and wealth but get standardised investment strategies from their wealth managers all the time. In times of individualisation, where clients can design their shoes online, should a client not also get a bespoke strategic asset allocation, considering that 90%[1] of the portfolio performance results from it in the long run?

Finding the best individual asset allocation for a client needs a lot of computing power and was made possible only recently by the vast computing power available in the Cloud.

d.    Wealth manager market’s view

Most wealth manager face the challenge that their market views are not fully integrated into their investment solutions. An example: if a wealth manager believes that interest rates will transition from negative to positive over the next three years, a multi-period risk framework is required. This view cannot be incorporated into a conventional one-period risk framework.

A sophisticated risk framework enables the instant calculation of a realistic wealth forecast based on the goals to be achieved; this allows the solution to be used in client meetings.

The use of the advisory solution in client meetings affects the value drivers of the wealth managers directly: they can finally incentivise their clients to disclose the whole wealth situation as the goal achievement of the client instantly improves if more is disclosed. This includes for example the assets held at 3rd-parties or non-bankable assets. With this know-how, the wealth managers can generate net new money, more revenues from cross-selling while being positioned as the trusted advisor to their clients.

Author: Marc Mettler, Head of Business Development, 3rd-eyes AG

[1] Roger G. Ibbotson and Paul D. Kaplan (2000). Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal (online), Volume 56