Goal-based financial planning is a framework to understand the possibilities offered by your financial resources, and account for investment risk and returns in a more tangible and meaningful way.
The utility of goal-based planning extends far beyond asset allocation in your investment portfolio.
Goal-based financial planning could help you plan your savings and expenses in line with future financial commitments.
Portfolio performance measurement yields more actionable insights when done with an eye on financial goals.
Rooted in the tenets of behavioural finance, goal-based planning could help reign in speculative behaviour.
The reason we save and invest is to accumulate the financial resources needed to live the life we want, free from the worry that the consequences our financial transgressions would catch up. Saving and investing is an essential part of realising our most important aspirations, like a debt-free education for our children, or the ownership of a home close to our family and friends.
Why then, should the framework that guides this process, with all its emphasis on technical ratios, benchmark returns, and asset correlation, be so far removed from what truly matters: the financial goals that we are saving for?
Goal-based financial planning is not only a way of dividing up your investment assets between equity and debt; more profoundly, it is a framework that could help you understand the possibilities offered by your financial resources, provide a yardstick to measure progress towards your financial goals, and account for risk in a more tangible way than just as a measure of market volatility.
As Matthew Rubin points of in an article for Advisor Perspectives:
“When we work with clients to design a customised portfolio, we need to understand their most fundamental goals. Goals lead us beyond the simple mix prescribed by a risk profile—conservative, moderate, aggressive—and help us understand how wealth fits into our clients’ lives and what they want to achieve with the assets they have accumulated. . .”
Goal-based investing first became popular in financial institutions in the form of Liability Driven Investments (LDI), which is now a standard practice for many pension funds and endowments. Consider a pension fund with its mandate to provide a retirement income to current and future pensioners. Its ability to meet the future pension commitments is far more important to the fund than any excess return it may generate. Since the fund knows with reasonable certainty when the pensions are due, with LDI it could create an asset allocation to ensure liquidity as per the payment schedule.
In much the same way, most of us have a reasonably good understanding of our future financial commitments, and we could use this concept to guide our portfolio construction, as well as the broader financial plan.
Plan ahead to ensure sufficient savings
At Clarified, it is a common refrain among our customers that they are not really sure about the specifics their future financial goals. Contrary to what some might think, this is not a flaw, but an essential strength of goal-based financial planning. We have consistently observed that the process of defining future financial goals in reasonable detail yields valuable insights, and informs a more meaningful financial plan. This happens is two important ways:
First, it forces you to budget for your goals quite early, ensuring that you know how much to save, and have sufficient time to save up. If for some reason additional saving is not feasible, planning early tempers your expectations of future spending on the goals. Second, as you invest these savings, you give the market more time to grow your corpus, potentially even making up for any shortfall in savings. Moreover, by associating your savings with a tangible outcome in the future you are more likely to stick to the budget you create.
Match asset allocation to the time horizon of your goals
In finance, volatility is a measure of risk. In other words, the more your investments fluctuate in value, the riskier they are. When investing for a long-term goal, short-term volatility is of little consequence if the investment, on average, is growing in value over time. But where short-term goals are concerned, there usually isn’t sufficient time for the fluctuation to average out; your portfolio could end up going down in value just as you need the money. There is every reason, then, to construct an aggressive portfolio with high potential returns and correspondingly high volatility for long-term goals, and a conservative portfolio with low volatility and correspondingly low potential returns for short-term goals.
The traditional approach to asset allocation - the division of investments among asset classes like equity shares, debt instruments, property, etc. - involves developing an understanding of the investor’s risk tolerance, and combining diverse assets with a low or inverse correlation of returns (i.e. assets that do not go up or down in value at the same time and to the same extent), to generate the highest possible portfolio return for the target risk level. The fundamental flaw of using the same asset allocation for all your goals is that your risk tolerance, as measured by a risk questionnaire, may be more than your risk capacity vis-à-vis a short-term goal. If such a portfolio declines in value at the wrong time, at best, you would be forced to redeem your investments at a loss, and at worst, you may not be able to fully finance your short-term goal.
A goal-based approach to financial planning involves creating a separate portfolio for each financial goal. While your risk tolerance still determines how risky the portfolios for long-term goals are, portfolios for short-term goals are nearly always conservative, comprising mostly debt mutual funds with investments in highly rated bonds of low residual maturity. Similarly, goal-based planning also gives you the option of creating conservative portfolios for high-priority goals like a higher education fund for your children, while retaining aggressive portfolios for good-to-have goals like a luxury vacation or a vehicle upgrade.
Measure progress, not just returns
Portfolio performance is commonly measured by comparing risk adjusted returns on your investments with those on the corresponding benchmarks. While useful for determining how well individual mutual funds in your portfolio have performed, this comparison offers almost no additional insights. This measure of portfolio performance says nothing about how near or far you are from achieving your planned financial goals; or whether any adjustment to your saving and investing strategy is needed in response to the portfolio performance.
For instance, the net asset value (NAV) of your equity mutual fund may have fallen by just 4% as compared to a 7% fall in the broader equity market - a comforting outcome, no doubt - but what is the implication, if any, on your target savings rate for an upcoming goal? Similarly, the higher education fund for your children may have clocked a compounded annual growth rate of 8%, but if tuition fees during the same period has grown at a higher rate, you are likely to come up short.
A performance measurement approach focussed firmly on realising your financial goals is far more likely to deliver an actionable set of insights. This approach involves, first, periodically reviewing your goals to make sure that your assumptions about goal value, timeframe, and the rate of inflation are still valid; and second, assessing whether at the current rate of progress you are likely to achieve the target corpus size. Sure, evaluating your mutual fund investments against the respective benchmarks is necessary as well, but it is by no means a sufficient measure of portfolio performance.
Many of the benefits of goal-based financial planning are rooted in an understanding of behavioural finance, a field of study that focuses on how individuals make decisions about their finances - and how emotions often come in the way of rational choices. Goal-based financial planning puts some of the most important aspirations of the your life at the centre of investment decisions, and pulls away from a potentially dangerous obsession with returns. By not chasing returns for returns’ sake, you are less likely to indulge in speculative behaviour and take on excessive risk.
As well as keeping a lid on the level of risk you take, a goal-based approach also helps you stay the course when the risk you did take creates short-term discomfort. When the return-seeking portfolios for your long-term goals suffer temporary losses, knowing that your short-term goals are safe with low-risk portfolios could prevent you from making impulsive and ill-informed decisions.
Published on: September 5, 2018