Goal Based Investing To Achieve More

Saving is all about sacrificing your present consumption for some future comfort or luxury. Therefore, there should be a compelling reason for you to cut your current spending so that you can enjoy the fruits at some future date. This saving needs to be invested so that inflation does not eat up your purchasing power. There are various instruments and products where you can invest and this can be done through goal-based investment. 

Goal-based investment came into prominence after the great recession of 2008-09. This event forced investors to reckon that chasing high returns could adversely impact their long-term wealth creation. It was not the first time in year 2008-09 that the prices of various assets collapsed simultaneously and investors lost money. However, what had changed during 2008-09 was the attitude of the investors. It forced them to change the way their portfolio was allocated and, secondly, investors came to terms with the fact that it might be the new normal (sharp fall in asset prices simultaneously) and not an aberration. 

Moreover, goal-based investment has also gained attention and appeal among the financial advisors recently because it helps individual investors to deal with dynamic asset allocation problem. It encourages an investor to invest now for their future goals, which can range from short term goals such as vacation to long term goals like retirement planning. 

Goal-based investing 

Goal-based investing at its core allows you to bucket your investments according to the purpose and the timeline required for the goal. It is easier said than done, as for any individual, there are multiple goals that may mature at different times. For example, you may be planning to buy a new car after two years, go for a foreign vacation after four years and buy a house after five years. Hence, you need to save and invest in various categories of funds that will help you to achieve these goals. Since different categories of funds are used to achieve your different goals, when we add up all these investments, it might not be an optimal portfolio. The critics of this approach argue that this strategy could entail unnecessary risk-taking and your diversification across the portfolio (built for different goals) may not be optimal and your portfolio might have uneven diversification. 

However, the above argument is based on risk defined in terms of standard deviation. This, however, may not be very intuitive for an individual investor. It may be incomprehensible for an investor to understand and translate the impact of a twostandard deviation event to their personal wealth or goals. 

The way he understands risk is how it is going to impact him in achieving his pre-defined goals. Therefore, now researchers have altered the way risk is defined. Risk has now been redefined; so rather than risk being defined as the volatility of returns, risk is defined as the probability of failing to achieve a set goal. This definition of risk addresses the critics who thought that goal-based portfolios might be sub-optimal. Hence, goals-based asset allocation is just an extension of Modern Portfolio Theory, with altered risk definition. 

Goal-Based Investing: The Process 

Understanding goal and defining risk The goal-based investing process starts with the investor articulating his various personal goals. These goals can be short term, medium term or long term and combination of all these. For example, your goal may include funding your next executive programme, buying new car, children's education and marriage or retirement planning. Once these goals are defined, the next decision that needs to be taken is to define the risk tolerance or deviation from each goal. Instead of using normal standard deviation as a risk measure, using the chances of meeting or not meeting the goal should be used as a risk measure. For instance, you will not be disturbed if you buy your new car after few months or year, but you cannot postpone your medical emergency or children's education. 

Hence, the tolerance to the goals will depend upon the type of goal. As an investor, you should be more focused on achieving your goal and would be least concerned with daily ups and downs in the asset prices. Therefore, defining risk in terms of probability of not meeting your goal is more intuitive. 

Use goal-based framework to set asset allocation targets 

Once you have decided your different goals, the next step is to do the right asset allocation for different goals. Therefore, for every individual goal, you need to set a sub-portfolio and that needs to be developed. The constituents of this portfolio will depend on the goal it has to meet and the certainty with which these goals need to be achieved. If the goal is such that you cannot skip, the instrument should be such that it should have less volatility and deliver predictable return. The intention of the entire process is to allocate your asset in a way that maximises the chances of achieving your goal. After all the individual portfolios are made, these should be then merged to form a single portfolio. 

Revisit asset allocation targets and goals on a regular basis 

Once you have decided on your asset allocation strategy depending upon the goals, this should be reviewed regularly. This will help you to know if the goals that you have set earlier are appropriately aligned with the investments. If not, you can take corrective action to align it again to the prescribed path. This will help you to keep check on current year's asset allocation process. It is necessary to review the portfolio, if not quarterly or half-yearly but at least on an annual basis, as failure to do so may result in the portfolio's inability to meet its stated objectives. 

Conclusion 

Mutual fund industry in India is relatively new compared to some of the manufacturing industries and service sectors and hence it will take its own sweet time to evolve and mature. The experience of other industry shows that it is not the product that attracts a buyer, but the solution it provides to the buyer. Goal-based investing is also like using mutual fund schemes to provide solution to your different goals. Hence, investors will be better off using mutual funds to achieve their different goals.