Foreword

by Jean LP Brunel, CFA

"The Private Bank is a distribution channel!" How many times have professionals who attempted to serve the specific needs of individuals heard that comment, way back when? Wait, was it really so long ago? The evolution in the nature of private wealth and of asset management (in the US in particular) inevitably led to the epiphany: Individuals are different, and they need different services.

Yet, if one goes sufficiently far back, private wealth was often inherited and structured around various trusts. That wealth had been accustomed to receiving services that were not necessarily quite different from those provided to institutions, except for the associated fiduciary services trusts required. After all, while the amounts may have been less substantial (although that was surely not always the case), it was felt that family trusts were very much like pension funds: long-term horizon and in need of the higher returns associated with a substantial exposure to equities. Further, trust beneficiaries had been used to seeing equity market fluctuations and had seen that down legs were followed by up legs. The final element had to do with delegation: trust beneficiaries had no difficulty delegating the management duties; in reality, they were not even delegating them, as those duties belonged to trustees. Beneficiaries expected to be briefed on portfolio performance but had very limited, if any, expectations of being able to influence portfolio decisions.

Eventually, the long bull market that started in 1982 and the wave of mergers and acquisitions that began in 1981 brought an important change to private wealth. "New" wealth appeared: the "old inherited wealth" that had dominated was increasingly joined by "new wealth," which had been more recently made or at least monetized.

"New wealth" had a different perspective of financial markets. The financial sophistication of individuals related to running companies, in other words, managing an income statement subject to balance sheet constraints; not of managing a balance sheet subject to income constraints. Their experience with financial markets frequently was limited. They did not always distinguish between a company and a stock, failing to appreciate the crucial issue of whether they were price makers or price takers. Finally, generational and potentially philanthropic structures that would work for them and their families had to be built: there were choices to be made and priorities to be assessed. There was the total novelty of how to bring the next generation into the wealth: "From shirtsleeves to shirtsleeves in three generations" ring a bell to anyone? They needed a variety of advisors, no longer relying on the formerly ubiquitous private banker, investment manager, and trust and estate lawyer.

It may have taken a while, but a response from the wealth management industry was bound to come. And it did, based on the work of people like Daniel Kahneman, Richard Thaler, Terrence Odean, Hersh Shefrin, and Meir Statman, to name but a few. These introduced the notion that individuals come with a number of biases and preferences that cannot be ignored. They provided the basis on which one could build. The classical belief that an investment policy must be the basis for the management of assets morphed into the appreciation that the sustainability of the policy is critical: The investor's worst enemy is the "changing horses in the middle of the race" syndrome. Behavioral finance effectively indirectly promoted the idea that policy sustainability would be greatly helped if one could create a link between "my wealth" and "my goals." It led to the recognition that I do not have a single risk profile; I may well have a risk profile for each goal, noting that each goal may also have its own time horizon.

Early in the 2000s, a few individuals independently came to the view that identifying individual goals and specifying the portion of the wealth that should be dedicated to each was important.1 The approach was originally named "goals-based wealth management." Unfortunately, the "s" of "goals" was briefly dropped, leading to the quip: "Is not goal-based wealth management very much like oxygen-based breathing"?

Four pioneers continued in their efforts and managed to convert a few people, but it took the seminal papers by Sanjiv Das, Harry Markowitz, Jonathan Scheid, and Meir Statman to truly open the path to the new discipline taking hold.2 In fact, prior to the publication of these two papers, the published literature made an uneven use of "fancy mathematics" rather focusing their rationale on behavioral concepts. Their first paper, though, broke that mold using sophisticated mathematics to demonstrate with elegance that the so-called "bucket approach" was virtually equivalent to the classical efficient frontier process, provided one made a couple of minor changes: the main change was the redefinition of risk away from the volatility of returns to the required probability of success in achieving a goal.

This book follows on the most recent tradition offering quite a bit of quantitatively driven analysis and demonstration. In many ways, it is a welcome return to the basics of the challenge: How do we help individuals achieve their goals in a way such that they will minimize the risk of "changing horses in the middle of the race"? At the same time, Franklin substantially broadens the analysis relative to what predecessors did. In that, the book is a must read, a must have. Rather than simply focusing on the question of formulating an investment policy, its purpose is to craft an entire theory around the concept of goals-based wealth management. Thus, the author moves from the fundamental framework of strategic asset allocation to a review of all the kinds of decisions that individuals should make as they embark on the journey and remain on it.

Time allocation, portfolio rebalancing, tax efficiency, thematic investing, and goals-based reporting are but a few of the issues the book tackles with brio. The crucial point, to this reader, is that there is no discontinuity or incongruity between adopting a sharp focus on goals and staying "pure" in relation to most traditional finance concepts. In fact, Chapter 13 gets to that point, presenting goals-based portfolio theory as a bridge between traditional and behavioral finance, the former being normative while the latter is descriptive.

Does this mean that we have reached the end of the road? The answer, in my opinion, is not a "simple no" but an "emphatic no." Goals-based wealth management opened the conceptual way to accept the reality that individuals can have multiple, and at times even superficially contradictory, goals. It proceeded naturally from the realization that wealth management was about a lot more than asset management. It all started with the notion that there were four stakeholders in "my wealth" and that individuals or advisors were particularly interested in three of them getting as much as they could while the fourth should be getting as little as possible. These four stakeholders were basic needs: the individual's personal needs, his or her family's and potential future dynasty's needs, his or her philanthropic needs or, eventually, those of his or her heirs and the needs to pay to the government taxes on income and transactions carried out in the taxable portions of the overall portfolio.

There is still quite a lot of potential work for those who want to extend Franklin Parker's portfolio theory to include the multiple asset location issues that can crop up. An example of such a strategy, which was timely at one point and may no longer be, were charitable lead trusts in a very-low-interest rate environment. They could facilitate efficient inter-generational transfers and accomplish charitable purposes as well. Their combined goals raised interesting investment and fiduciary issues, particularly as the assets had not terminally exited the family's ownership; only the part that went to charity had.

There are many other examples that one could point to, though the newest category seems to me to relate to the role of insurance products. Historically, investors have tended to eschew insurance, or at least eschew it as a part of a truly holistic wealth strategy. A common concern was that insurance comes with a cost. Some of that cost appeared to make sense, another part appeared too expensive, and individuals elected to self-insure. Yet, a broader evaluation of the issue may help see an intriguing analogy to the thought processes that at one point led advisors away from considering a single overall portfolio solution. Insurance companies must be paid for the risk they take; on the one hand, however, from their points of view, that risk is diversified across a large number of insured clients. On the other hand, from the point of view of each client, the outcome is often purely binary: I die, or I do not die; I live out my life expectancy or I do not, and many variants on the theme. Thus, the cost of purchasing the insurance (which should be determined here from the point of view of the solitary insured) is and should be dramatically different from the cost of selling insurance (which should be determined from the point of view of covering a diversified pool of insured). Is there not a potential arbitrage there?

Historically,...