Setting goals is an efficient way to accomplish almost any task. Ask any athlete, coach, teacher, or financial advisor. In financial planning, meaningful goals are the emotional payoff that helps you delay gratification and stick with our plan to achieve what really matters to you.
It is for this reason that most financial planners start with goals. One way they use them is to estimate the cost of that it will take to fund each goal, and design a savings plan to achieve them. Or given a savings plan, advisors they can estimate the likelihood of achieving stated goals. Some advisors even use some characteristics of your goals, like the time horizon or the reason for the savings (income vs. wealth creation, for example) to help define the risk profile to use in selecting the riskiness of your portfolio.
Goals-based investing goes a step further. It uses the information contained in each individual goal, including their value, priority, and time horizon, to build a dedicated investment portfolio for each goal. This leads to a more purposeful portfolio and allows for adaptable strategies that improve the long term performance of your investment plan. Don’t take it from me. Research by Robert C. Merton, Professor of Finance at MIT and Nobel Laureate, supports the claim that goals-based investing improves the performance of your portfolio by allowing for more dynamic investment strategies.
How the goals-based approach works.
To see how goals-based investing works, suppose you have the following goals. You want to save for a down-payment on your first home in two years, your child’s college education in 10 years, and your retirement in 25 years. How should you invest your savings? The short horizon and importance of making the down-payment on your home mean you should take very little or no risk with the savings devoted to this.
In contrast, your retirement goal allows for much more flexibility. First you’ll be funding most of this goal with future planned savings. This means that short term fluctuations in your retirement portfolio have less impact on your ability to achieve the goal. Second, you may also have flexibility in terms of retirement age and planned spending. As a result, the retirement goal allows for a relatively high allocation to risky (and potentially high-return) assets like stocks.
Your child’s education goal is high priority with a 10 year horizon. Where it stands on the risk-return scale may depend on your particular situation. However, we can think of it as being between the other two goals. A moderate allocation to stocks is likely consistent with this goal.
The approach can accommodate much more complex situations and detailed plans. For example, consider the retirement goal. It’s unlikely that a single number, like $80,000 a year, can summarize your retirement goal. You may find that you need $50,000 to cover essential expenses, but have some degree of flexibility with the remaining $30,000 desired expenses. So you construct a more conservative income portfolio for the $50,000 goal and a relatively riskier portfolio with the rest of the assets devoted to the desired expenses.
Why it works
There are three important benefits from the approach:
- Clarity
- Risk Management
- Over time performance
Clarity: an eye on each goal
If you have only one portfolio for all your goals, how do you know how you are doing relative to each goal any time the portfolio changes value? Suppose you have $420K saved so far, you have college expenses coming in a few years, you are saving towards a new home, and would like to accumulate to start a business within a few years. Your risk profile says a 50/50 portfolio is appropriate for you and you invest the $420 accordingly. How are the savings distributed across your goals? Suppose next month your portfolio goes down about 10% to $375K. How is the loss distributed across your goals?
With a goals-based investment approach, each goal (college, home, business) has its own portfolio, with the level of risk appropriate for the priority, horizon, and risk preference for each goal. For example, the amount dedicated to the new home may be entirely in bonds and suffer no loss, while business goals, on which you have some flexibility in terms of timing, may absorb most of it. As you monitor your portfolio, you always know how you are doing relatively to each goal. If what you see is not in line with your preferences, you can reallocate current and future savings to match your most current goals and priorities.
Better Risk Management
Risk management has two main roles in asset allocation: avoiding poor outcomes and reducing unnecessary risks. The first is addressed by investments with little or no risk, typically, bonds or bond funds. You may look at a stocks/bonds mix and ask: by how much can I expect the value of the portfolio to drop in a given year (or other horizons)? If that’s too big for you to weather, you may increase the allocation to bonds until you find a level that you are comfortable with. However, the definition of risk is different for each goal. You may not have much flexibility on the downpayment of 20% of the value of your dream home, so you can’t take much risk there. However, you can take more risk with your retirement portfolio if you are over 20 years from retirement. The benefit of using your goals is that you don’t have to rely on a risk questionnaire to set the level of risk in your portfolios. Your goals clarify what risk means to you.
The other advantage of goals for managing risk is that bonds and bond funds aren’t all the same. They too, have different risk and return characteristics. It turns out that the risk of different bond funds depends on the horizon of your goals. For example, short term bonds are good at managing short term volatility, while long term bonds may be useful in managing the risk of long term goals, like retirement income. Matching the bond portfolios to your goals helps you avoid unnecessary risks and improve long-term performance.
Over time, the horizon of your goals declines, and with it, the ability to bear the risk to achieve them. A goals-based portfolio easily lets you adjust the level of risk for each goal over time. Below is an example of a typical risk profile for a retirement goal. But a similar approach can be applied to any goal.
Allocation of a retirement income portfolio, by age
For illustrative purposes only. DESMO Wealth Advisors, LLC.
An eye on the big picture: monitoring and improving performance over time
The performance of any plan needs to be measured in relation to its goals. Here is the true benchmark: Are we making the best use of our savings to achieve stated goals? With goals-based investing, the performance of the plan is tied to the goals from the start. This lets you monitor the performance of each part of your portfolio in relation to its goal. You can decide to monitor on a quarterly basis, during large market changes, and if your goals and priorities change. A goals-based plan allows you to make simple and meaningful adjustments. Is your progress towards high priority goals going better than expected? Shift a greater fraction of your savings towards lower priority goals. Are market returns lower than expected? Consider the impact of increasing your savings, or changing some of the goals, in terms of priority, time, and size.
How to do it in practice: Talk to A Fee-Only Advisor In Austin TX
Goals-based investing requires you to set clear and meaningful goals. Each goal contains a dollar amount, a time horizon, and a priority. These are used to derive both a portfolio for each goal and a savings plan. When you start, a sensible plan is one in which you expect to achieve your goals with a reasonably high level of confidence. Over time, technology can help you figure out how each part of your investment plan is doing relative to its goal. At DESMO, we use technology from Betterment for Advisors to develop your investment plan, continually monitor performance, and make adjustments over time. We also make some tools to get you started available online. If you are planning for retirement income, you can check our post to make a retirement income projection.
Examples of Goals And Priorities
Source: Betterment
Goals-based investing works because your investments are constantly aligned with your goals and priorities. By continually using the information in your goals and priorities to adjust your saving and investment plan, you can increase your long-term performance and the likelihood of achieving your goals, relative to standard approaches that rely on generic portfolios based on risk preferences.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. 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.
