Evaluating Performance and Focus on What’s Important

By: Anthony Cristiano

The importance of diversification has been trumpeted for over a thousand years.  Many centuries ago, a Rabbi recommended that investors have “a third in land, a third in merchandise, and third ready at hand.”  Advice on diversification and asset allocation didn’t change until the recent past when Harry Markowitz in 1952 published the origin of modern portfolio theory “Portfolio Selection”.   It posed the thought that investors can use estimates of return and volatility to build optimal portfolios and enhance outcomes through diversification.   This theory is the genesis for most portfolio discussions today, although investors are still struggling for a way to effectively implement it.

Pension plans and other institutional investors have gradually taken a different approach over the last decade. Instead of creating portfolios purely on risk-adjusted return, they began focusing on matching their investment strategy to their goals. What they’ve found is that such a framework provides better perspective in regard to performance and decision-making as they progress toward their goals.

Individual families can learn from this as well. Most investors have future objectives that they’d like their investment assets to meet—such as paying for college tuition, buying a vacation property, funding retirement, or leaving an inheritance. Goals-based investing can be very helpful in designing a plan to meet those objectives.

The heart of goal-based investing is the concept of “bucketing,” or segmenting investment assets into three portfolios that we refer to as liquidity, longevity, and legacy. The liquidity bucket holds three to five years of spending needs, the longevity bucket holds assets that will be necessary to meet the household’s objectives over its lifetime, and the legacy bucket holds surplus assets that can be designated for inheritance or charitable purposes.

There are four crucial benefits to this strategy:

1. It is dynamic. The liquidity, longevity, legacy approach makes it transparent where a household stands relative to its goals, and ties its investment decisions to the objectives in its financial plans. As the household gets closer to each specific goal, assets flow from the longevity portfolio into the liquidity portfolio, which appropriately de-risks the assets being used for those goals.

2. It is behavioral. Recent behavioral economics research shows that segregating safe assets into a separate portfolio can actually help investors make less emotional decisions regarding the remainder of their assets during periods of market peril. For example, by holding a liquidity portfolio (three to five years of planned spending in ultra-safe assets), investors might not feel compelled to sell equity holdings if market prices plummet, because their basic spending needs are preserved for the next few years.

3. It is more than just financial assets. Individuals accumulating assets should certainly consider their disability insurance to be part of their longevity portfolio, since a disability that significantly reduces their cash flow would be a devastating blow to their future plans. The same is true regarding pensions, Social Security, life insurance, and long-term care insurance at various parts of the life cycle.

4. It coordinates portfolio performance to your financial plan.  Goal-based investing enables investors to connect their investment performance to their financial plan and focus on progress toward their goals instead of less important measures like market performance.  According to Dr. Richard Thaler, a professor at the University of Chicago and one of the founders of the field of behavioral economics, he states “benchmarks are one of the great evils in preventing successful investment at every level.”  The S&P500 might have returned 1.19% in 2015, but the index does not know you or care about your goals.  Therefore we see this as an arbitrary benchmark.

Goals-based investing requires investors to focus on long-term absolute performance in the context of their financial goals, instead of comparing their portfolios to index returns. In addition, since the bucketing approach is based on anticipated future liabilities and cash flows, it ties directly to a financial plan.  It tailors a strategy to investors for them to achieve the highest probability of success in fulfilling what is most important to them in life:  Can I retire?  Can my children go to the college they desire?  Will I outlive my money? Can I leave an inheritance to my children?

The most common way for measuring the comprehensive effectiveness of a financial plan is probability of success, or the percentage chance of hitting your desired goals. This valuable performance metric incorporates initial asset levels, age, asset allocation, annual savings, and the timing of goals. It then replicates thousands of possible return sequences to determine the likelihood that an investor will be able to achieve his or her designated liabilities (goals) in the future. Although we are not advising investors to ignore their annual performance metrics, we are recommending that investors take into account the total picture and focusing on what is important:  Am I closer to achieving my goals?  If not, what can I do differently to increase my probability of success?  This should encourage better decision-making and hopefully better performance over time.

Authored by UBS Financial Services Inc., provided courtesy of Anthony Cristiano, First Vice President and Financial Advisor

“UBS Financial Services Inc. and its affiliates do not provide legal or tax advice. Clients should consult with their legal and tax advisors regarding their personal circumstances. As a firm providing wealth management services to clients, we offer both investment advisory and brokerage services. These services are separate and distinct, differ in material ways and are governed by different laws and separate contracts. For more information on the distinctions between our brokerage and investment advisory services, please speak with your Financial Advisor or visit our website at ubs.com/workingwithus. ©UBS 2015. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS Financial Services Inc. is a subsidiary of UBS AG. Member FINRA. Member SIPC”

Anthony Cristiano heads the Cristiano Group, a wealth management team at UBS Financial Services in NYC. He is a First Vice President and Portfolio Manager. In addition to his practice advising affluent families and executives, Mr. Cristiano is also a Senior Retirement Plan Consultant at UBS, providing guidance to Corporate Retirement Plans. The primary focus of the Cristiano Group is to provide objective, comprehensive wealth advice to their clients. In conjunction with his firms’ world class resources, his team provides a holistic approach to wealth management, one that is inextricably linked to the unique needs, goals and values of each client.