The Cost of Certainty

Someone recently wrote the following on my podcast SubReddit (I will just report an extract of the relevant part):

I set myself a clear goal: to reach around €1 million in assets within 12–13 years. The million is not a random number, but a threshold that would allow me—if I wanted to (or had to, in the event of being laid off)—to stop working or, at the very least, to enjoy strong financial independence.

This person has a legacy portfolio, which we can refer to as a starting Asset Allocation, and can add a recurring amount for the next 10 years. He thinks that his current AA, 100% stocks, is too aggressive to reach his goal. In other words, he wants to prioritise reaching the goal rather than surpassing it by a lot.

So what type of AA should he move to if his goal is to be sure he will have 1m in 12 years?

The “Defined Benefit Pension” Strategy

We’re looking at a dynamic Asset Allocation (AA) model, the kind of thing it is used for Defined Benefit (DB) pension schemes. The idea is simple: if you’re ahead of schedule, you take chips off the table. If you’re lagging, you press the bet.

In a vacuum—no taxes, no inflation—the math says a dynamic model that changes the risk profile aggressively wins. It tells you to de-risk when you’re close to the goal, to avoid a “sequence of returns” nightmare before you hit the finish line, or to up-risk when you are drifting away.

But you don’t live in a vacuum. You live in the real world.

The Friction is the Lead Weights

Here is where this plan starts to fall apart:

• The Tax Man: Every time your “dynamic model” tells you to pivot from stocks to bonds because you’re “ahead of target,” you’re triggering a taxable event. You’re paying the government for the privilege of lowering your expected return. Congratulations, you just handicapped your own compounding.
• The Inflation Monster: You want to de-risk into “plain vanilla” bonds? Good luck. If inflation spikes, those “safe” bonds are going to get shredded. You’re trading market volatility for a guaranteed loss of purchasing power. 12 years is a blink of an eye in market terms, but it’s plenty of time for inflation to turn your €1M goal into €700k in today’s money.

Taking these elements into consideration, you need to build the AA thinking about how the different elements behave during inflationary shocks (both up and down), which is very complicated when the horizon is rather short (as in this case). Also, what matters to you is your own personal inflation rate—your own basket. Using inflation-linked bonds can only partially solve the issue…and they offer even lower expected returns than plain vanilla bonds.

The “Goal-Based Investing” Tax

The industry loves to sell “Goal-Based Investing” (GBI). It sounds so personal, so tailored. But GBI is basically an insurance product in a not-so-fancy suit.

The claim of GBI is that you should not care about returns, reaching your financial goals is the real deal. Which is exactly how the DB scheme sponsor thinks. The sponsor doesn’t care if the pensioners get a bigger payout, it wants to contribute to the pot the minimum possible and let the market do the rest of the job.

This is a fascinating parallel with the institutional world. When a company wants to offload its pension liabilities to an insurance company, it usually pays a 15% premium (the technical nuances of pension regulations are beyond the scope of this post, but the 15% premium is rooted in the ‘buyout’ market, where pension liabilities are transferred to a third party. This transaction is typically priced using a more conservative valuation of the scheme’s liabilities. It is important to note that this 15% figure isn’t driven by ‘insurance greed,’ but by a competitive market with numerous providers. While the premium fluctuates over time like any market price, 15% serves as a reliable long-term estimate).

15% is the market price for “certainty.”

Why? Because providing a guarantee is expensive. Ask your FIRE calculator. Or better, an annuity provider.

[Most likely, there is a duration component behind that 15%. But considering that most GBI goals have a duration of 5 to 10 years and a Golden Butterfly has a 3% annual real return premium over 10-year Govies, 15% feels about in the right ballpark?]

What the GBI proponents never tell you is the cost of putting your objectives in front of a more ‘generic’ asset allocation.

Let’s say you want to buy a house in 10 years. You can take 2 fundamental approaches:

• you can invest your wealth at the highest return you can get for your risk appetite – maximise terminal wealth
• you can invest to maximise the probability of reaching that specific goal – the GBI philosophy

The terminal wealth strategy can still reach the goal in many scenarios, it is just less likely to do so compared to the GBI one.

That 15% is the market cost to decide to pursue the GBI way instead of the max terminal wealth way. 15% is realistic because it includes the insurance company’s profit but also their expertise. When your advisor tries to “DIY” a GBI strategy for you with four bonds and a spreadsheet, he’s trying to recreate that insurance hedge without the scale or the tools. The “DIY” approach of your GBI advisor is most likely less efficient than the insurance one (the Insurance Co can pool many similar risks, your advisor cannot pool your “boat risk” with the “swimming pool risk” of another client; and they also don’t have access to leverage in the form of LDI).

You’re paying a massive opportunity cost for “peace of mind”.

Flexibility is your greatest asset

The more I study, work, and interact with people about financial topics, the less I understand the GBI approach. The biggest flaw in GBI is the assumption that your goals are static. Or worse, pay the opportunity cost like they are.

If you remove from the picture the “I want to send my son to Harvard” financial goal, all the other possible objectives are quite flexible in terms of due date. Therefore, you don’t need high certainty and can adopt a max-Sharpe portfolio. There is also an additional consideration: if you still want to buy that boat while the stock market is in a depression, the likelihood that the cost of that boat has gone down is pretty high. As for that house. In other words, your risky portfolio and your goals (outside of pension) are pretty correlated anyway.

The nice characteristic of efficient portfolios is that they come with a low Ulcer Index: if they are in a drawdown, they recover reasonably fast. And the best characteristic of running an efficient portfolio is that you can concentrate on it. You do not have different buckets, pockets, pyramid layers to look after and wonder what they are doing and why: you just have one portfolio.

Do you want to buy a boat? Look at your portfolio balance. Do you want to buy a boat in 5 years? Wait 5 years and look at the portfolio balance. Maybe after 3 years your pal would have sold his boat and explained to you why owning a boat is a bad idea…and you do not have to change your financial plan. Maybe you were planning to buy a house in 10 years and after 3 you got an incredible job offer in another country. Now the house is off the table. Or maybe it will be again, who knows. Still, your portfolio is there.

Life is rarely that linear. With GBI, you trade the growth of an efficient portfolio for a “safe” path toward a goal you might not even want by the time you get there. And you are going to pay 15% for that.

What you want is a portfolio that offers you the most options regardless of what life throws at you.

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