How do you actually construct sub-portfolios in goals-based asset allocation?

Question

AcadiFi · Accepted Answer

Goals-based allocation uses a structured process that's more nuanced than just running separate MVOs. Here's how it works:

**Step 1: Identify and Classify Goals**

Goals are typically categorized by importance and time horizon:

| Priority | Description | Required Success Rate | Example |
|---|---|---|---|
| Essential (Needs) | Must be funded | 85–95% | Living expenses, healthcare |
| Important (Wants) | Strong desire | 70–85% | Home renovation, travel |
| Aspirational (Wishes) | Nice to have | 50–70% | Legacy, philanthropy |

**Step 2: Determine the Module (Sub-Portfolio) for Each Goal**

Each goal is assigned a *module* — a pre-built portfolio with a known probability distribution of terminal wealth. Think of these as pre-set mixes:

- **Module A (Conservative):** 80% bonds, 20% equities → High probability of modest return, low downside
- **Module B (Balanced):** 50% bonds, 50% equities → Moderate probability of moderate return
- **Module C (Aggressive):** 20% bonds, 80% equities → Lower probability but higher potential payoff

**Step 3: Match Goal to Module**

The key insight: you select the module that, given the time horizon and capital allocated, has the required probability of meeting the goal's funding need.

**Worked Example:**

Client: Dr. Martinez, age 55, $3M portfolio

| Goal | Amount Needed | Horizon | Priority | Module | Allocated |
|---|---|---|---|---|---|
| Retirement income | $2.0M | 10 yrs | Essential (90%) | Conservative (A) | $1.7M |
| Beach house | $600K | 7 yrs | Important (75%) | Balanced (B) | $500K |
| Grandchildren trust | $400K | 20 yrs | Aspirational (50%) | Aggressive (C) | $300K |
| Cash reserve | $100K | Now | Essential (99%) | Cash | $100K |
| **Total** | | | | | **$2.6M** |

Note: $3M − $2.6M = $400K surplus. This surplus can be allocated to the aspirational goal, improving its success probability, or held as additional buffer for essential needs.

**Step 4: Aggregate to Overall Portfolio**

The overall portfolio is just the sum of sub-portfolios:
- Total equities: (1.7M × 20%) + (500K × 50%) + (300K × 80%) = $340K + $250K + $240K = $830K (32%)
- Total bonds: (1.7M × 80%) + (500K × 50%) + (300K × 20%) = $1.36M + $250K + $60K = $1.67M (64%)
- Cash: $100K (4%)

**Why Not Just MVO for Each?**
Because goals-based allocation explicitly connects each dollar to a purpose. MVO would give an 'optimal' mix but wouldn't tell the client whether their retirement is funded with 90% confidence. The goals-based framework makes trade-offs transparent: if you want a more aggressive overall portfolio, you can see exactly which goal becomes less certain.

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How do you actually construct sub-portfolios in goals-based asset allocation?

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