Many a time, we invest without having a specific purpose in mind and end up redeeming to fund goals which may not be so important. Thus, a better approach to investing is by prioritizing your important goals and start building a nest egg to achieve these goals. Simply put, goal based investing is putting aside a certain portion of savings to achieve a purpose, say buying a home, higher education, etc.
This article focuses on how goal based investing helps investors achieve better outcome. To begin with, let’s look at the steps involved in goal based investing.
4 steps of designing a goal based portfolio
Describe each and every goal, include the specific time horizon and details of cash flows and required probability of success
Identify the minimum return necessary for specific time horizon and required probability of success. This can be done with series of generic modules designed to meet specific goals or based on individual optimization of portfolio.
Use that return as discount rate to the present value of the asset.
Once sub-portfolios are created they can be used together to form the investors investment policy.
How individuals experience goals-based wealth management
Normally, in a traditional portfolio, the happiness of the investor depends on the performance of the portfolio. On the other hand, in goal based investing, the investor is more focused on achieving a goal and not on the returns. Thus, he/she starts to identify with each and every goal and starts tracking them.
In goal-based investing investors spend a considerable time identifying the goals, time horizon and degree of urgency of each goal. This helps them take a huge step towards better understanding their relationship with their wealth. Investors understand how much of their wealth is used for meeting their goals. They identify what portion of current asset is required to finance goals and this changes their perception and to an extent on their spending patterns.
Have we improved investor’s outcome?
When we talk about the outcome we do not talk about returns. It is not necessary that goal based investing will always give better returns; nobody says it is more efficient!
But the main benefit of this approach is that it helps investors get a better understanding of how investments work, what to expect from them and realize the limitations of markets. Also, they become more aware about their risk-bearing ability and their goals. Ultimately, it motivates them to invest before they spend.
Reproduced substantially from the whitepaper ‘goal based investing’.