Morningstar - Q3 2020 - 32

Spotlight: Be Prepared

EXHIBIT 1

Goals-Based Risk Planning A process
to find a plan that is both plausible and
palatable to the investor.

Step 1

Identify:

No

gGoal
gInvestable Wealth
gTime Horizon
gSavings Rate

Plausible strategy?
Yes

Step 2

Show expected volatility in the
long term.

No

Acceptable to investor?
Yes

Step 3

Show expected volatility in the
short term.

No

Acceptable to investor?
Yes

Step 4

Implement and maintain.
Source: Morningstar.

32

Morningstar Q3 2020

Conversely, if clients indicate that they are
"uncomfortable" or "very uncomfortable" with the
expected volatility, then there is a clear
disconnect. In these cases, investors have some
constructive options. They can reduce expected
volatility by increasing the amount of time
before drawdown, increasing the amount of
investable wealth, increasing their contribution
and savings rates, or by scaling back on the
magnitude of the goal. These are four "dials"
investors have control over. Investors can't control
what the markets do, but it is worth reminding
clients what they do have control over.

careful reasoning and deliberate disciplined action.
The other mind is hot, emotive, impulsive, and
responds rapidly and automatically. The mindset
people typically have when making a financial plan
is almost certainly not the same mindset
that will execute their plans. By developing an
integrated financial planning process that includes
steps that are both cognitive and emotive,
people can make a financial plan that mitigates
both investment risk and behavioral risk.
Good financial planning attends to both minds, but
this is hard to do. Goals-Based Risk tries to do it in
a systematic way.

Step 2 uses a mix of methods to measure risk
aversion and loss aversion (Kahneman and
Tversky, 1979) within the context of long-term
investing strategies. And it does so to ensure that
there is agreement between the different
factors at play. If clients want to change their
approach, they could iteratively tune the dials
(essentially making necessary trade-offs)
until they reach a configuration that serves their
financial goals with an anticipated volatility
they can tolerate. This kind of dynamic explorable
explanation (Victor, 2013) leverages the power of
fast, responsive, and interactive software
in helping people understand their preferences,
financial goals, and the constraints that make
it difficult to know exactly what to choose when
making investment decisions. The approach
is beyond what traditional, static paperand-pencil-type measures such as risk-tolerance
questionnaires can offer.

One purpose of Step 3 is to give clients the
experience of month-to-month changes
in their portfolio over a simulated year or even
multiple years. The simulated returns are
calibrated to reflect the individual's investment
strategy and expected performance based on real
market data (entailing both fat tails and
autocorrelations). Moreover, changes in wealth are
not simply reported as a percentage change
but as real dollars based on the amount clients
have invested. This is not hypothetical
wealth-this is client money in real dollars. This
kind of computer-based gamification (for example,
see Sironi, 2016) is done to make the context
both more realistic and personally meaningful to
an investor. Instead of being told, "The market was
down 5% last month," the client would learn,
"In January, you lost $5,230 of your money!"

Step 3: Helping an Investor Feel What
a Sufficient Strategy Will Be Like
Investors need to know-and more important, feel
deep down at a gut level-what the experience of
volatility will be like for them over their time
horizons. If people have the wrong expectations of
what turbulence will be like, they are much
more likely to panic and make unwise moves. Good
financial planning should help people have
well-calibrated expectations about what their
gains and losses are going to feel like.

A core idea is that people are of two minds
(called dual process theory in psychology; see
Kahneman, 2011). One mind is cold, calm,
calculating, and aims for solving problems with

During this step, investors would have the chance
to modify their investment strategy. People
who are prone to perceiving fallacious patterns in
random stimuli (a tendency called pareidolia)
or people who have very strong emotional
reactions to losses and downward volatility (that is,
loss aversion) will be more likely to adjust
their strategies when faced with turbulence.
This iterative step of the planning process
provides insight into the individual difference
of risk reactivity, which is a different psychological
construct from risk aversion or loss aversion.
Risk reactivity is the stability of people's risk
preferences as they experience changes
in their wealth and receive new information. We
posit that too much attention has been
devoted to understanding and applying risk
Morningstar - Q3 2020

Table of Contents for the Digital Edition of Morningstar - Q3 2020
