Financial planning helps you achieve your most meaningful goals in life. This post helps you set your own goals and discusses how to use your goals to drive the design of your financial plan and your investment allocation.
The Why, What, and How of Financial Planning
At DESMO, we start the financial planning process by discovering your values. We make a distinction between values and goals. Values represent what’s important to us. They are the why of our plan, like time with family, experiences, sense of purpose.
Goals are measurable objectives that require planning to achieve. If values are the why of the plan, goals are the what of the plan. Determining goals is also crucial in determining the actions you are going to take to maximize the likelihood of achieving them. Designing a set of actions (a strategy) that works for you is the art and science of financial planning.
We have this equivalence
Values → Goals → Actions
Why → What → How
The how in financial planning typically requires a long term view, a change in behavior, and perseverance. Planning is a process, not a one-shot deal. The only way to engage in the process is knowing that you are working towards goals (the what) that are meaningful to you. Goals are meaningful only if they are aligned with your values (the why).
What are goals?
A goal is a pair, consisting of a dollar amount and the timing of when the amount is expected. It is important to have both elements or the goal is not meaningful. Examples of goals are: make a down payment on a house in 4 years or buy a new car or a new bike in 5 years. The goal can be a simple lump sum, or it can be a recurring payment, like $40,000 a year in income when I retire in 10 years, or a new $30,000 car every 5 years.
The power of clarity
Writing down goals this way is important for two main reasons: Clarity and risk management. Goals make it clear what you are working towards. Once you set goals this way, financial software can make it relatively effortless to find the cost of each goal, and how much we have to work to achieve each of them. This clarity can be crucial in affecting our behavior. First, you can see how your hard-earned money is helping you achieve your goals. While a 20% return may not mean much to you, knowing that you are 80% done towards your kid’s college fund will make you feel pretty good about your progress. Similarly, going through a rough patch in the stock market may be scary, but you may find that it is not meaningfully impacting your retirement goal. This clarity can help you make better decisions. Saving half of your bonus can be easier if you know the impact it will make towards important goals. Clarity can also help us to prioritize our goals. When we set multiple goals, say college, retirement, and a home purchase, we may struggle to decide how much to allocate to each. Knowing how we are doing relative to each goal may help us decide, for example, to dedicate more of our tax refund to the college savings goal this year, since it is fast approaching.
Risk Management
How much risk you can take in your investments should depend on your goals. If you have a down payment a year from now, you probably don’t want to take any risk with your savings. But you can take much more risk with your retirement savings if you plan to retire in 20 years or more. Many advisors may ask you to go through a risk questionnaire to determine the mix of stocks and bonds that is appropriate for you. That may be helpful, but asset allocation should start from clearly defining your goals. Here are some examples of goals in a plan.
Cash reserve Cash reserves are used for payments that more or less predictable, including planned expenses over the next few months to a year. While you may be able to earn some interest on your cash reserves, they are typically not invested in securities like stocks and bonds.
Safety net This typically refers to a buffer for unexpected expenses, like the loss of a job, over the next two to five years. Part or all of the safety net can be invested in liquid securities, typically in a conservative allocation, with equities at less than 20%.
A big purchase Things like a new car for your 16-year-old or new bike to celebrate your 40/50/60..or Nth birthday. Once you set the goal, you can estimate the amount you need to devote to it over time, and you can assess how much risk you are willing to take for the goal. Taking more risk can lower the amount you need to set aside for the goal each month, but it increases the risk of not achieving the goal. If you have some flexibility, either with the goal (a slightly less expensive model) or with making corrections to your savings down the road, you can take more risk.
Start a business This is similar to a big purchase. Again, the time horizon and the flexibility you have can help you decide how much risk to take for the goal. In this case, you may be flexible about timing, how much you may need to start the business, and how to come up with the funds.
College education This is similar to a big purchase, but you probably don’t have a lot of flexibility and the risk you are willing to take may not be that high, particularly closer to college enrollment. The duration of the goal, like 2, 4, or more years, should be part of your investment horizon.
Retirement The retirement goal can subsume multiple goals. One goal is retirement income to replace the income we earn during our working years. This goal is a stream of dollar amounts throughout retirement. For example, $50,000 a year from age 65 to age 90. Other goals can be lifestyle-related, like traveling once a year to a different country ($5,000 per trip) for the first 5 years in retirement.
Bequest This is also similar to a big purchase. You can decide to set a goal for how much you want to leave to your loved ones or your favorite charity at some point in the future.
Isn’t it all coming from the same pot?
Yes and no. Your savings across all your goals are part of your total net worth. But if you just set a broad asset allocation, you lose both the clarity and risk management elements we discussed. Put another way, you should think of any piece in your asset allocation as serving a purpose for your goals. If you simply set an overall asset allocation, you cannot see how each individual piece in your investment portfolio is working towards your goals.
For example, the risk you are taking towards each goal may be changing without you realizing it. Consider this scenario. You have to make some unexpected expenses for which you use cash in your checking account and sell some liquid bonds. Do you realize the risk in your portfolio has just gone up? Which goal is being affected the most? Assume right after you make the expenses the stock market takes a nosedive. Are you selling investments at a loss to readjust your asset allocation to the desired level? Which goals are realizing the loss? And by how much?
When properly set, goals are a reflection of your values and represent measurable objectives for you to work on. Your plan should be designed around your goals. They should define the actions you need to take to achieve them, how to properly allocate your savings across them, how to manage your risks, and how you monitor and celebrate progress.
Talk to us about our goals-based investing approach to learn more about how to align your investments and your financial planning to your goals.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
