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Goals Based Investing is an investing technique which focuses on investing based on different goals of the investor.

Traditional Investing Approach

In the usual approach of investments, an individual invests in different funds based on professional advice and investor’s research. The allocation of these funds keeps changing as per investors age and market scenarios. Investors might also choose to consult a professional wealth manager for funds allocation. In both cases the objective of investments is to increase the capital to a target level while minimizing the risk. In such investments asset allocation changes to reduce the risk as the capital reaches target level or at the end of investment period for eg retirement of investor. This risk reduction leads to more investments in bonds/FD from equity. This ‘one-size-fits-all’ strategy is practiced by multiple wealth managers and AMCs across the globe. This easily followed strategy has number of flaws:

• It does not take into factor the individual needs of investor. Not all investors might want to maximize capital, instead some have other objectives such as to repay their mortgage or buying bigger home or funding kid’s education.
• It doesn’t account for capital appreciation before the investment horizon. For eg in case of unexpected bull run the capital will appreciate which might lead to high risk capability of investors.
• It also doesn’t consider intermediate capital requirement of investor. Unexpected capital needs might present itself to investors such as in case of emergency, in such time the investments should be at certain level and sufficient liquidity.

Goals Based Investing – Introduction

Goals based investing recommends investors to set life goals and constructing a number of subportfolios for each one. That is, goal-based approaches are two-step approaches. First, the investor decides how to split his or her wealth among the different investment goals. Second, each investment goal is treated separately and a specific portfolio decision problem is solved. This considerably simplifies the portfolio decision process and investors are more likely to understand and follow their strategies. With goal based investing, the focus of the investment approach is on funding the personal financial goals. Goal based investing is similar to asset-liability management (ALM) for insurance companies and pension funds. The goals based investment redefines the risk for the investors. Risk should not be defined as the standard deviation of return but as the probability of not achieving goals, which is the way that most people intuitively define risk.

The goals based investing stands on two pillars:

1. Designing investors goals based on their needs and life style
2. Designing a methodology for goal oriented dynamic allocation strategy. This approach reduces the risks and improves the feasibility of the clients’ goals.

Designing the Goals

The first step in the process is to determine goals which will lead to optimal asset allocation. Simple goals might be like

1. Goal: I wish to save for retirement. The terminal capital at the retirement date is used to buy an annuity. This approach will follow traditional approach of capital maximization.
2. Goal: I wish to save for a mortgage. The capital will be used to pay off a mortgage at a fixed date. To minimize the downside risk of not being able to repay the mortgage, it is desirable to gradually transfer to a cash portfolio. The strategy in this case will be a stepwise reduction of risky asset classes to cash.
3. Goal: I wish to buy a house. Mix of risky and safe assets can be utilized for this goal. If the invested capital is not as per requirement at realization date, a smaller capital will also serve the purpose or alternatively the buying decision can be postponed to a relatively later date.

Goals can be more advanced in nature and can have multiple objects ranging from:

• Expenses – reoccurring withdrawals (living expenses)
• One time cash flows (buying a house, art, etc.)
• Capital targets
• Conditional cash flows (children’s education/wedding)

Critical component in the advanced goal based strategies is the prioritization of objectives or differentiation in the ability and willingness to take risk in reaching these goals depending on their importance:

• Non discretionary goals: Non-discretionary goals need to be covered with a high level of certainty (80%-100%).
• Discretionary goals: usually, small deviations from the target are not a cause for concern.
• Exceptional cash flows may be conditional to the development of the capital. Disappointing returns lead to delay or redefinition of the objectives.

Investing for Goals

Once the investor has defined different goals, the investment strategy for each one of them can be different and dynamic. Goals demaning high level of certainity require safe investments, while goals which are flexible will have the appetite of relatively risker options. Flexibitliy of goals can majorly be attributed to timings and amount.

• Goal A: These are the most sacred goals. Fixed nature of both Value and Timing signifies that the investor should have the exact defined amount at exact defined time, anything less or anything late wont suffice. Investments for such goals would include ultra safe options like digital gold. Planning for emergency situations like medical emergency also falls into this category and buying a insurance is also a great alternative.
• Goal B: These are the goals which matures at a defined date but are flexible in nature of the value. An investor planing a vacation next year falls into this category. The maturity is defined which is next year but the value can be flexible which will ultimately define the destination. Such goals are best invested in relatively high risk investments but should be liquid enough to be realized well in time.
• Goal C: An investor planning to buy a house will need to have a defined value but timining can be varied. Such goals are under this category and are best invested in relatively safer options but can be less liquid in nautre.
• Goal D: Aspirational Goals comes under this category. Investor might want to achieve these but not able to suceed wont affect their lifestyle. The investment for these goals can be allocated to much more risker asstes.

While designing investment options for above type of goals following features of investments need to be factored:

• Risk and return properties such as means, volatilities and correlations vary with the investment horizon. Based on data from 1802 to 1990 the correlation between nominal equity returns and inflation is negative for an investment horizon less than one year, negligible for an investment horizon of one year, and significantly positive for an investment horizon of five years. Also the volatility of equity returns decreases and the volatility of bond returns increases with the investment horizon.
• Non-normal returns: mean-variance optimization assumes that returns are Normally distributed. However, empirical data clearly shows that return distributions have fatter tails than the Normal distribution, and are skewed.
• Tail risk: correlations between asset classes increase in the left tails of the distribution. The 2008 financial crisis has shown us again that in bear markets the correlations between asset classes increase sharply. Consequently, the diversification effect which should protect a portfolio melts away in times of market losses, just when it would most urgently be needed.
• Business cycle dynamics: For example, stock prices tend to lead in the business cycle while real estate returns typically lag in the business cycle.
• Volatility of an asset class, like equity, is not a fixed characteristic. It is dependent on return levels. When equity return levels are negative, volatility is high.

Ignoring one or more of these real world features may impact the strategies adopted by the investors, resulting in incorrect conclusions and actions.

Conclusion

Use of Goals Based Investing approach is superior to the ‘one-size-fits-all’, target date oriented static allocation path used by most investors. The two pillars of the suggested approach: designing the goals: and designing investing strategy customized for each goal and dynamic in nature. This approach reduces the risks and improves the feasibility of the investors’ goals.