Vol. 19, No. 2, 2021
Investment managers require a consistent asset pricing model, asset allocation recommendations, and risk-adjusted performance measures (or the “three facets of investing”) to be effective in managing portfolios. Incorporating three critical realities of investing into these models (i.e., that investors have many stochastic goals, seek to delegate to skillful agents, and maximize risk-adjusted returns) provides recommendations on the three facets that are different from the foundational papers of Modern Portfolio Theory (MPT). This paper briefly surveys the literature on MPT, Goals-based Investing (GBI), and agency before providing a normative Goals- and Risk-Based Asset Pricing Model (GRAPM) that includes these three realities of investing and articulates the three facets. GRAPM exploits a simple idea that a relatively risk-free asset for one stochastic goal is a risky asset for another, and vice versa. These two assets, plus the traditional absolute risk-free rate of MPT, allow us to triangulate to establish returns for all other assets based on the return of any goal-replicating asset and multiple correlations. This approach creates a “pair-wise equilibrium” for all assets (and potentially a general equilibrium)—different from MPT— and also lends itself easily to a new asset pricing model with heterogeneous investors (i.e., each investor has a unique goal). GRAPM incorporates a “risk aversion” parameter that is also easily observable, and appears to explain why seemingly similar investors can have markedly different asset allocations or expected returns.