Conquer financial goals with goals-based investing

Map out and meet your investment goals

Adam McCullough, CFA 14 March, 2019 | 2:00PM
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Investing anything--time, effort, or money--sacrifices short-term reward for a long-term payoff. Sometimes investors lose sight as to why they’re investing. Goals-based investing offers a useful structure to map out concrete investment goals, prioritize them, build portfolio to meet them, measure progress against them, and make adjustments (if necessary) to stay on track.

Setting specific and challenging goals improves performance by increasing motivation[1]. The benefits of setting goals extend to investing by improving investor behavior. Goals-based investing forgoes an optimally efficient portfolio for the potential to improve investor behavior. A plan that you can’t stomach isn’t worth pursuing. Morningstar’s Head of Retirement Research, David Blanchett, found that a goals-based framework for financial planning led to a 15% increase in utility-adjusted client wealth.

An advantage of goals-based investing is that you can tailor a portfolio specific for each goal, prioritize them based on the impact of not meeting them, and monitor progress of meeting that goal. This differs from traditional portfolio management, which views all assets holistically. Modern portfolio theory dictates that assets should be viewed together to take advantage of their varying correlations to build the most efficient overall portfolio.

Goals-based investing could lead to suboptimal allocation that doesn’t maximize investors’ total return given a level of risk because it does not consider interaction between goal-specific portfolios. Although using goals-based investing may not build the theoretically optimal portfolio, it may improve investor behavior and increase the likelihood of financial success.

Lather, rinse, repeat

Goals-based investing is a framework to translate financial goals into forecast future expenditures and allocate money to separate portfolios designed to meet those specific goals. The process of goals-based investing follows a cycle.

Specify well-defined investment goals.
Well-defined goals are easier to prioritize and match an appropriate portfolio to meet them. Using the SMART--Specific, Measurable, Action-oriented, Realistic, and Time-bound--goal-setting framework helps establish clear goals. The objective of goal setting is to define future financial outlays. Goals-based investing may surface uncomfortable questions or faulty assumptions. But identifying these early may help investors get back on track by modifying or reprioritizing their financial goals.

Prioritize goals based on necessity and time horizon.
High-priority goals are those that are indispensable. The impact of not meeting them is high. An example of a high-priority goal could be making the down payment on a house in a few years. Low priority goals are aspirational; the impact of missing them is low. A low priority goal may be saving for a dream vacation in 15-20 years. Rigorous prioritization helps ensure that you’re set up well to meet your most important goals.

Build investment portfolios to achieve financial goals.
Conservative investment portfolios are likely best for high-priority goals with short time horizons. This is because the impact of not meeting these goals is high and there’s less opportunity to recover from poor market performance over short-term horizons. On the other end of the spectrum, it makes more sense to use aggressive investment portfolios to fund low-priority, aspirational goals with long time horizons. The impact of missing aspirational goals is low. Long time horizons allow more time to bounce back from poor market performance.

Measure progress/make adjustments

Undoubtedly financial situations change. The portfolio plan should be reevaluated and modified when necessary. An advantage of goals-based investing over traditional holistic investing is the ability to measure progress toward individual investment goals. Life events such as getting married, changing jobs, or having kids can serve as catalysts to measure progress toward financial goals, update investment strategies to better position yourself to meet your goals, or to reprioritize them

Putting it all together
An example will help illustrate the considerations at each step of the goals-based investing process.

Specify well-defined investment goals
Let’s assume that I have two financial goals that are well-defined and meet the SMART goal-setting criteria:

1) Make a 20% down payment on a $250,000 home in five years.

2) Fund 100% of a child’s university education in 20 years.

Prioritize goals based on necessity and time horizon.
I decide to prioritize my goal of saving for a down payment on a home because the impact of not making the down payment is high. This goal also has a short time horizon of five years. Funding 100% of a child’s education is lower priority for me than making the down payment on a house. I could fund less than 100% of my child’s education because there are other funding sources available such as scholarships, grants, and student loans.

Build investment portfolios to achieve financial goals.
I’ll focus on building a portfolio for my high-priority goal--making a down payment on a home. Let’s assume that I have $35,000 saved toward this goal. With a well-specified, time-bound goal, it’s easier to quantify the target for the goal. The funding gap for the down payment measures $15,000. This equals $50,000 (20% of $250,000) minus the $35,000 saved.

The next step is to build a portfolio to cover this $15,000 funding gap. I can afford to contribute $150 per month toward my housing down payment goal. Given the funding gap of $15,000, a timeline of five years, and a monthly contribution of $150 per month, I find that I’ll need to earn about 2.85% per year on the $35,000 that I have saved to reach my target of $50,000 in five years.

This is a high-priority goal with a short time horizon, so the impact of not meeting it is high. I elect to use the defensive model portfolio as a starting point to build a portfolio to accomplish this goal. The defensive model portfolio allocates 60% to stock funds and 40% to bond funds. Because my home down-payment goal requires 2.85% annual return to meet it, I decide to reduce the equity allocation to 30% and increase the bond allocation to 70%. Allocating more toward bonds creates a more-conservative portfolio. This reduces the portfolio’s expected risk and return but also narrows the range of investment outcomes. Because my required rate of rate is 2.85%, which is relatively low, I’m fine with the lower expected return.

Monte Carlo simulation is a useful tool to test the likelihood of reaching the portfolio return goal of 2.85%. A Monte Carlo simulation runs thousands of potential return and risk outcomes of the specified portfolio and offers a range of likely outcomes based on the distribution of simulations. The website offers a free Monte Carlo simulator. Per portfoliovisualizer, the expected average return of the modified defensive portfolio outlined in Exhibit 3 is 4.1%, and it has a 75% chance of generating returns of 3.2%. Take these figures with a grain of salt, but a modified defensive portfolio should allow me to achieve my financial goal of making a 20% down payment on a $250,000 home in five years.

Measure progress/make adjustments
Undoubtedly financial situations change. I’ll reevaluate this portfolio in a year or when a major life event occurs.

Rolling with the punches
Although goals-based investing does not offer a holistically optimal portfolio, breaking up future expenditures into concrete goals, prioritizing them, creating a plan, and monitoring progress could increase investor success by promoting good behavior.

When using goals-based investing, keep these three things top of mind

1) Be as detailed as possible when setting and prioritizing financial goals--a better defined target and honest prioritization sets you up better to accomplish your financial goals.

2) Use appropriate portfolios to fund goals--conservative portfolios are a better bet for high-priority, short-term goals while aggressive portfolios make more sense for low-priority, long-term goals.

3) Don’t set it and forget it--periodically measure progress toward financial goals and adjust prioritization if necessary.

[1] Locke, E. 1996. “Motivation Through Conscious Goal Setting.” Applied & Preventative Psychology, Vol. 5, No. 2, P. 117 – 124.


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About Author

Adam McCullough, CFA

Adam McCullough, CFA  Adam McCullough, CFA, is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies.

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