When we invest, we make an important choice not to spend money today so that we can live better in the future. This means we have a goal or a reason to invest in the first place. Otherwise, what’s the use of investing?
Why not start from that goal when we build an investment strategy? Individual investors are not institutions. We have a limited time horizon, we pay taxes, we sometimes react emotionally to swings in the market. Building portfolios for individuals should be different.
Standard practice is to assess an individual’s total risk tolerance and recommend an investment allocation that’s roughly in line with the client’s appetite for risk. Goal-based investing goes a step further. What is the purpose of these investments? How much is the future spending goal, and how much risk is the investor willing to take that they will fail to meet this goal?
A new stream of literature in finance asks the question: What does it actually mean to develop portfolio strategies that focus primarily on the goal that motivates the investment today? After all, people don’t just invest to build wealth. They set money aside today for a future purpose. Maybe it’s to fund spending in retirement or to pass on a legacy. But investing is a means to an end, and the end is what’s really important.
The Spending Goal
Goal-based investing assumes that the spending goal should drive the investment strategy. An investor can be relatively risk tolerant, but if their spending goal is not flexible (for example, medical spending or living expenses in retirement) then the investment portfolio should reflect the inflexibility of the future goal. And the investments selected today to meet that future goal should be those that offer the highest expected after-tax payout for the amount of spending flexibility an investor is willing to accept.
In a 2012 article in the Journal of Financial Planning, Duncan Williams of the University of Georgia, Wade Pfau of The American College and I argued that spending flexibility is how we should define risk tolerance when matching a portfolio allocation to a future spending goal. If we can be more flexible with our spending goal, then we can take on more investment risk.
How do we manage a risky portfolio over time in order to meet a future goal? Goals are tricky because they are often fixed, say, $2 million for retirement, but they must be funded with investments with unknown future returns. High investment returns mean the goal is more easily funded. Low returns mean that an investment plan can be derailed.
What does it mean when asset returns don’t measure up to expectations? From the perspective of a goal-based planning philosophy, it means that the investor may fail to meet their goal — unless they take some sort of corrective action.
In a 2011 study published in the Journal of Wealth Management, Anil Suri, managing director and head of portfolio analytics for Merrill Lynch, detailed a goal-based investing process that helps investors understand how they are making progress toward their goal and then gives them the tools they need to make the right corrections along the way.
“Instead of thinking of what’s going on in the markets,” said Suri, “think about whether you’re on track and making progress to achieving your specific financial goals.”
This means working with a client to set realistic goals with a defined time horizon and an acceptable level of risk. What does risk mean in a goal-based planning framework? Through the magic of statistics, it’s possible to establish a minimum acceptable probability of meeting a goal.
If the goal is not flexible, then a client may establish a 90% or 95% probability of meeting the goal. For a more aspirational goal, it may be acceptable to set a 60% probability. (Remember that if you’re plugging in historical averages to estimate future returns, you’re starting with a 50% probability of success.)
Risk & Returns
This is where statistics comes in handy. The average historical geometric return on a 10-year investment in a balanced U.S. stock/bond portfolio is 7.4%. The client can fully immunize the goal today by investing in a zero-coupon Treasury bond paying 3% that will mature at the goal date. But most investors will be better off accepting a certain amount of investment risk. This means that returns could be lower than the bond, but more than likely will be higher — especially over a long-run time horizon (more on this later).
It makes sense to assume a portfolio return that is higher than today’s 3% 30-year zero-coupon Treasury rate. How much higher is determined by the composition of the portfolio and how flexible you are willing to be with the goal.
Historically, the 20th percentile of balanced portfolio returns is 4.8% in the U.S. The cost of funding a $2 million goal with Treasuries will be $42,039 per year. Assume a 4.8% return on a balanced portfolio with an 80% probability of success, and the client can save $31,152 a year, or more than 25% less.
I find this approach attractive for a number of reasons. First, it helps the client understand the tradeoff of not taking investment risk. If you don’t take risk, you’ll have to invest more today to meet your future goal. But if you do take risk, there is a chance that you won’t meet your goal. That’s what investment risk is all about. This helps a client understand how risk affects financial goals.
Second, it helps a client understand tradeoffs when they get unlucky. If your portfolio falls by 10% over the year, you need to accept the reality that the probability of reaching the $2 million goal by saving $31,152 a year has decreased below 80%.
The good news is that you can use statistics to estimate how much more you need to save each year to maintain the same probability of success. If the increased savings rate isn’t going to fit within a client’s budget, then they either need to face the choice of accepting a reduced probability of success (say 75%) or a new goal target (say $1.8 million).
Suri likens the annual portfolio evaluation to traveling with Google Maps. When you’re driving toward your destination, Google will provide the best directions at the time you leave. However, traffic may change along the way and the app will recommend a course correction.
Let’s also talk about some advisor myths that need to be busted. If you’re assuming a historical portfolio return when projecting how much a client needs to save to meet a goal, then you are building in (at least) a 50% chance that the client will fail to meet this future goal amount with the savings plan. This is what a normal distribution means.