CHAPTER 30
Constructing an Investment Portfolio to Support Family Goals
Jean Brunel and Voyt Krzychylkiewicz
Traditional finance has trouble dealing with the needs of individuals. Most investment solutions have been developed for the institutional client with the relatively simple objective of maximizing risk-adjusted returns. While institutions typically have this singular goal, individuals and families tend to have multiple goals with different horizons and with multiple different stakeholders in mind (including children and charities among others). Furthermore, not all goals are equally important, nor do they all cost the same amount.
It is typical for families to think through their goals early on, particularly when a liquidity event transforms concentrated single security wealth into more liquid financial assets. However, goals are dynamic, and the passing of time and underlying investment performance may require families to periodically revisit their goals and the resultant financial asset allocation.
As a result, there is often more than one opportunity to consider the following twin questions:
- What are our financial goals, their time horizons, and the requisite certainty of attaining these goals?
- Does my current asset allocation align with these goals?
Note that many goals-based discussions focus largely on the first of these questions, but it is important to tackle the approach from both perspectives. Further, when considering how to adjust your current asset allocation to align with goals, it is important to factor in costs, most notably taxes, which may impact how, and even if, this can be executed efficiently.
The purpose of this chapter is to explain the process of constructing an investment portfolio that supports your family's specific goals. At times, the exercise itself can become quite technical and may require the help of an investment advisor, but our aim is for you to understand the process and put you in a position to ask yourself, as well as your advisors, better questions about your portfolio construction.
Setting Goals
Though some families find it relatively easy to set out their major financial goals, they do not always appreciate that setting goals must be done in an iterative fashion to reflect both their available current (and future) assets as well as the risk tolerance that is required to achieve their goals. It may even become obvious that no reasonable strategy, short of purchasing the proverbial lottery ticket, will do the trick to meet all of a family's goals.
Let's use common language to separate family goals into four categories: Needs, Wants, Wishes, and Dreams. First, let's define these four items before considering how you may practically convert your goals into an investment strategy.
- Needs include fixed expenses to maintain your current standard of living and for which you require a very high level of certainty. However, you do not have to restrict your thinking to the basics of survival—for example, food and shelter. For some people, they may have a “need” for tithing or charitable giving, maintaining a second home, or an annual trip to visit children. The principle is to identify items that are a necessity or key obligation where you have little tolerance for failure. In our following statistical analysis, we express needs as a goal that requires a greater than 90 percent probability of success.
- Wants, by contrast, may include more discretionary items where you have a desire for something but are comfortable absorbing greater risk of these not being met (perhaps greater than 80 percent probability of success).
- Similarly, your Wishes and Dreams include items that are less critical to achieve. This does not necessarily mean that Wishes or Dreams are “less important”; it may be just that they are more aspirational in nature and so are less likely to be achieved. For our following statistical analysis, we use a greater than 70 percent probability for Wishes and greater than 50 percent for Dreams.
Clearly, the goal-setting process is highly personal. You may even have your own language to describe the ranking of your goals, but the aim is to develop a hierarchy of goals considering the relative necessity to achieve them.
After developing this hierarchy, the next step is to understand the financial implications of the various goals as well as the respective time frame for each. This may involve your financial planner or family office building more detailed cash flow forecasts that also factor in other items such as expected income or sizable one-off purchases. This approach of starting with your goals contrasts with that taken by many wealth managers (and indeed, regulators), which seek to set a single risk rating based on the individual or their level of knowledge of investment products. In truth, the risk sits with each goal, and of course a single individual or family will have multiple goals with differing risk appetites.
The following table may provide a useful framework as you map your goals. We have included several examples of types of goals, although these are not intended to be prescriptive since this process is highly personal to each family and may also include nonfinancial goals that could be addressed through planning work beyond investments (e.g., tax structuring, philanthropy planning, succession planning).
Let's consider the example of the Patel family. The Patels are a couple with adult children who have $50 million of investable assets and net annual expenditure of $1 million per year. In our example, the family has four goals, which we have included in our table:
- They need to maintain an emergency reserve sufficient liquidity to meet lifestyle expenses for the next three years.
- They want to maintain the same lifestyle for the next 15 years.
- They wish they could give $10 million to their children in 5 years.
- They dream about funding a foundation with $20 million in 20 years.
| Value | Time Horizon | “Probability of Success” Requirement | |
|---|---|---|---|
| 1. Needs | |||
| 1.1 Maintain sufficient liquid capital for next 3 years | $1 million p.a. | 0–3 years | 95% |
| 1.2 Financially support children until independence | |||
| 1.3 Financially support parents or broader family | |||
| 1.4 Other | |||
| 2. Wants | |||
| 2.1 Maintain current standard of living | $1 million p.a. | 3–15 years | 80% |
| 2.2 Acquire art or other collectibles | |||
| 2.3 Complete home renovation | |||
| 2.4 Other | |||
| 3. Wishes | |||
| 3.1 Provide a gift to children in future | $10 million | 5 years | 70% |
| 3.2 Purchase additional vacation property/second home | |||
| 3.3 Purchase luxury asset such as a yacht/aircraft | |||
| 3.4 Other | |||
| 4. Dreams | |||
| 4.1 Set up and fund own family foundation | $20 million | 20 years | 60% |
| 4.2 Fund family's entrepreneurial ventures | |||
| 4.3 Donate to charity | |||
| 4.4 Other |
Identifying Subportfolios to Support Each Goal
For each of these goals (or other goals you want to include, with their own distinct required probabilities of success), we need to develop a unique subportfolio of financial assets to support each unique goal. The key point is that the mix of financial assets will likely be very different for each goal due to the underlying risk of the investment assets and time to realize the goal.
Generally speaking, a Need in the near term (say, less than five years) should likely be backed with low-risk financial assets where there is greater certainty of the outcome. These financial assets may include cash or short duration bond portfolios. By contrast, Dreams and Wishes or goals in the distant future may be backed by higher risk assets, such as public or private equity. The reason we can use higher risk portfolios to back longer-term goals is that there is time to recover from short periods of underperformance. Effectively, the variance (or volatility) of investment outcomes reduces over long-term horizons, making long-term performance more predictable than short-term performance.
Returning to the Patels, let's assume they have the option to invest in six distinct investment portfolios running from conservative (Portfolio A—low return and low volatility) to aggressive (Portfolio F—high return and high volatility). The illustrative six subportfolios have different underlying asset class exposures as outlined below.
| A | B | C | D | E | F | |
|---|---|---|---|---|---|---|
| Cash | 80% | 26% | 3% | 1% | 1% | 1% |
| Investment Grade Bonds | 20% | 44% | 45% | 25% | 0% | 0% |
| High-Yield Bonds | 0% | 5% | 11% | 25% | 34% | 4% |
| Low Volatility Alternatives | 0% | 9% | 13% | 0% | 0% | 0% |
| Real Estate | 0% | 5% | 5% | 3% | 3% | 0% |
| Equities | 0% | 11% | 15% | 22% | 35% | 60% |
| Equity Alternatives | 0% | 0% | 8% | 24% | 27% | 35% |
These six subportfolios create something that resembles a reasonable efficient frontier1 as can be seen in the following chart.
Now that we know the investment alternatives, how do we decide which portfolio to invest in for each goal? Recall our earlier comment that shorter term goals or those requiring high levels of certainty (i.e., Needs and, perhaps, Wants) will typically be invested in more conservative portfolios. Long-term goals or goals with lower levels of required certainty (i.e., Dreams and Wishes) can typically be invested in higher risk/return asset classes.
While this “rule of thumb” may be useful, we can be more specific by looking again at the expected investment returns and expected volatility of our six portfolios2 shown below.
| A | B | C | D | E | F | |
|---|---|---|---|---|---|---|
| Expected Return | 1.5% | 2.9% | 4.3% | 5.9% | 7.2% | 7.8% |
| Expected Volatility | 2.2% | 4.3% | 6.0% | 8.0% | 10.2% | 13.3% |
When looking only at expected returns, it is tempting to suggest that all capital should be allocated to the portfolio with the highest return potential—portfolio F in this case. However, remember that there is a 50 percent chance of doing better than the expected return and a 50 percent chance of doing worse. Obviously, the concern for many families is performing significantly worse than the expected returns and, as a result, potentially jeopardizing the family's goals.
This is where volatility comes into it. Portfolios with higher expected volatility have a wider range of expected potential outcomes and so may not be suitable for certain goals. Your advisor can carry out some statistical analysis looking at what impact the volatility has on returns based on certain probabilities.
The following table shows that there is a 95 percent probability that the expected return of Portfolio A will be –2.2 percent or better in any single year. By contrast, there is 95 percent probability that Portfolio F delivers –14.1 percent or better. This suggests that Portfolio A provides a higher expected return where a family requires a 95 percent probability of meeting its goal (i.e., a Need). To simplify matters, we have bolded the portfolio with the highest expected return based on differing levels of probability. As you can see, as the required probability of a goal diminishes, portfolios with higher expected return and higher expected volatility become more suitable.
| Annualized Minimum Expected Return (1 year) | ||||||
|---|---|---|---|---|---|---|
| Probability | A | B | C | D | E | F |
| 95% | –2.2% | –4.2% | –5.6% | –7.3% | –9.6% | –14.1% |
| 90% | –1.4% | –2.6% | –3.4% | –4.4% | –5.9% | –9.2% |
| 80% | –0.4% | –0.7% | –0.7% | –0.8% | –1.4% | –3.4% |
| 70% | 0.3% | 0.6% | 1.2% | 1.7% | 1.9% | 0.8% |
| 60% | 0.9% | 1.8% | 2.8% | 3.9% | 4.6% | 4.4% |
| 50% (i.e., the expected return) | 1.5% | 2.9% | 4.3% | 5.9% | 7.2% | 7.8% |
The table shows the expected minimum return for one-year periods only, so we need to do a similar exercise for longer-term horizons (e.g., 5- and 20-year horizons). You can see that as the time horizon is extended, the higher risk portfolios deliver higher expected returns even at higher levels of required probability of achieving your goals. Again, this should be intuitive—if we have a long investment horizon, we are able to take more investment risk as more volatile and high return investments have more time to recover from any periods of weakness.
| Annualized Minimum Expected Return (5 years) | ||||||
|---|---|---|---|---|---|---|
| Probability | A | B | C | D | E | F |
| 95% | –0.2% | –0.3% | –0.1% | 0.0% | –0.3% | –2.0% |
| 90% | 0.2% | 0.4% | 0.9% | 1.3% | 1.4% | 0.2% |
| 80% | 0.6% | 1.3% | 2.0% | 2.9% | 3.4% | 2.8% |
| 70% | 0.9% | 1.9% | 2.9% | 4.0% | 4.8% | 4.7% |
| 60% | 1.2% | 2.4% | 3.6% | 5.0% | 6.0% | 6.3% |
| 50% (i.e., expected return) | 1.5% | 2.9% | 4.3% | 5.9% | 7.2% | 7.8% |
| Annualized Minimum Expected Return (20 years) | ||||||
|---|---|---|---|---|---|---|
| Probability | A | B | C | D | E | F |
| 95% | 0.6% | 1.3% | 2.1% | 3.0% | 3.4% | 2.9% |
| 90% | 0.8% | 1.7% | 2.6% | 3.6% | 4.3% | 4.0% |
| 80% | 1.0% | 2.1% | 3.2% | 4.4% | 5.3% | 5.3% |
| 70% | 1.2% | 2.4% | 3.6% | 5.0% | 6.0% | 6.2% |
| 60% | 1.3% | 2.6% | 4.0% | 5.4% | 6.6% | 7.0% |
| 50% (i.e., expected return) | 1.5% | 2.9% | 4.3% | 5.9% | 7.2% | 7.8% |
Going back to the case of the Patels, recall that they had a Wish of providing their children with $10 million of capital in five years. Using the table for five-year returns and a 70 percent required probability, we can see that subportfolio E provides the highest expected return of 4.8 percent per annum. Similarly, for their 20-year Dream of setting up a family foundation (using a 60 percent required probability), we can see that subportfolio F would be optimal, providing a return of 7.0 percent per year.
Combining Subportfolios to Develop Your Investment Portfolio
Once the optimal subportfolios have been identified for each unique goal, they can be combined to develop the overall investment portfolio as shown in the following table. In the case of the Patel family, the good news is that they have sufficient capital to meet all four of their goals and would even have excess capital ($26.2 million).
This excess capital can be used to increase current goals, such as boosting the amount of the gift to their children or adding additional goals in the future. They could also increase the required probability for some of their goals. Similarly, if they did not have sufficient capital to meet all their goals, they would need to extend the time horizon, reduce the amount, or reduce the required probability.
For our purposes, we have assumed the Patels are comfortable with the current goals and have decided to invest their excess capital into a “moderate” subportfolio while they evaluate any changes to their goals (Portfolio D).
| Goals | Surplus | Total | ||||
|---|---|---|---|---|---|---|
| 1 | 2 | 3 | 4 | |||
| Investment Horizon | 3 | 15 | 5 | 20 | ||
| Required Success | 95% | 80% | 70% | 60% | ||
| Optimal Subportfolio | A | E | E | F | D | |
| Required Capital ($'000) | 3,039 | 7,667 | 7,907 | 5,124 | 26,263 | 50,000 |
| Required Capital (as a % of total) | 6.1% | 15.3% | 15.8% | 10.2% | 52.5% | 100.0% |
| Asset Mix | ||||||
| Cash | 80% | 1% | 1% | 1% | 1% | 6% |
| Investment Grade Bonds | 20% | 0% | 0% | 0% | 25% | 14% |
| High-Yield Bonds | 0% | 34% | 34% | 4% | 25% | 24% |
| Low Volatility Alternatives | 0% | 0% | 0% | 0% | 0% | 0% |
| Real Estate | 0% | 3% | 3% | 0% | 3% | 3% |
| Equities | 0% | 35% | 35% | 60% | 22% | 29% |
| Equity Alternatives | 0% | 27% | 27% | 35% | 24% | 25% |
| Total | 100% | 100% | 100% | 100% | 100% | 100% |
Additional Considerations
While the process just outlined shows how to convert your goals into an investment portfolio, there are several other practical considerations and questions which you should ask yourself and any relevant advisors:
- How different is the optimal portfolio from our current portfolio?
- What would the transaction costs be (such as taxes or costs to unwind structures) if we rebalanced the portfolio immediately and is it feasible to carry this out?
- Is our investment portfolio sufficiently liquid such that we can easily rebalance?
- Can we make use of derivative strategies that could help in rebalancing the portfolio?
- Can we use other strategies such as insurance to mitigate certain risks (e.g., longevity) and support specific goals?
- Outside of return objectives, do we have any other goals that relate to investments, such as impact or lifestyle investing?
- How do our transition or succession plans impact our goals and resultant investment portfolio?
- If we have capital in excess of what is required to meet our goals, do we want to increase or change some goals?
Conclusion
It can be daunting to decide how to invest your hard-earned wealth, particularly given the ever-growing list of asset classes and complex, yet intriguing, alternative products that exist today. However, it is important to remember that you are not seeking to optimize your financial assets. Your financial assets are only a tool as you seek to achieve your goals, which may indeed mean that you forgo potential returns in order to increase certainty of achieving your desired outcomes.
The process just described highlights how each family, with its own unique goals and circumstances, will ultimately require a unique investment portfolio to support the realization of these goals. It is also worth remembering that this process is not static and that it is necessary to reflect on your goals periodically to ensure your portfolio still supports these goals.
Additional Reading
- Franklin Parker, “Goal-Based Portfolio Optimization,” The Journal of Wealth Management (Winter 2016): 22–30.
- Jean L.P. Brunel, “Extending the Goals-Based Framework to Comprise both Investment and Financial Planning,” The Journal of Wealth Management (Spring 2020): 21–46.
- Daniel Kahneman, “Thinking Fast and Slow” (New York: Farrar, Straus and Giroux, 2011).
- Jean L.P. Brunel, “What Should Your Asset Allocation Be?” In Wealth of Wisdom, Tom McCullough and Keith Whitaker (Hoboken, NJ: Wiley, 2018).
Biography
Jean Brunel is the managing principal of Brunel Associates, a firm serving ultra-high-net-worth families. Prior to 2001, Jean spent most of his career with J.P. Morgan, becoming, in 1990, the chief investment officer of J.P. Morgan's global private bank. He has been the editor of the Journal of Wealth Management since its 1998 founding and authored two books—Integrated Wealth Management: The New Direction for Portfolio Managers, by Euromoney (2002, 2006), and A Practical Guide to Goals-Based Wealth Management by John Wiley & Sons (2015). In 2011, Jean received the C. Stewart Sheppard award from the CFA Institute, was named the 2012 Multi-Family Office Chief Investment Officer of the Year by Family Office Review, and was the first recipient of the J. Richard Joyner Wealth Management Impact award from IMCA in 2015. He is a graduate of HEC in France and holds an MBA from the Kellogg School of Business.
Voyt Krzychylkiewicz is a vice president at Northwood Family Office and chairman of its Investment Committee. Prior to joining Northwood, Voyt led the investment function as an executive at a global publicly traded investment holding company where he concluded more than $1 billion of direct private transactions. In addition, he was the CEO of its real estate investment subsidiary and chaired the group's investment committee. His investment career started as an equity analyst in South Africa where he was the top-rated analyst covering banks and specialty financial sectors. He has sat on the boards of 13 private and public companies within the financial services and property sectors and is president of the Young Directors Forum. He is a CPA, CA, and a CFA Charterholder and completed his executive MBA at the University of Toronto's Rotman School of Management.