What is goals-based investing and how does it work?

Modern portfolio theory (MPT) argues that it's possible to design an ideal portfolio that will provide an investor with maximum returns by taking on the optimal amount of risk, chiefly through diversification. In the 68 years since Harry Markowitz first published his theory, MPT has become the default strategy for portfolio construction.

MPT isn't without its shortcomings, however, and anyone invested during the dark days of the Global Financial Crisis could tell you how difficult it is to diversify away systemic risk on such a grand scale.

Perhaps the biggest failing of the traditional approach to asset allocation is how divorced it is from the full breadth of an investor’s requirements. Most high-net-worth investors will have a clearly defined set of financial goals they want to achieve, such as maximizing their income in retirement, purchasing a second property, funding their children’s education, or perhaps a combination of the above.

This broad range of goals is commonly addressed using the traditional asset allocation model, focused on optimizing asset class mix in order to get the best risk/return balance for the investor. But given how diverse these goals are, both in terms of immediacy and importance, it may not be the most effective approach for an investor. This is where we believe a goals-based approach to investing can offer an advantage.

Goals-based investing differs from traditional asset allocation by linking separate investment portfolios to specific goals. Investors are willing to take different levels of risk with different goals, and by creating a separate portfolio for each goal, each with a different risk profile and time horizon, it’s possible to tailor the allocation toward achieving a specific goal.

Let’s consider an investor who wants to save for retirement while simultaneously looking to fund the purchase of a vacation property. These competing goals come with different time horizons and degrees of importance; the amount of risk acceptable for buying that vacation property in two years’ time will be different from a retirement date that’s 10 years away.

Using the traditional asset allocation portfolio to cover both of these goals, and any others in between, the short-term focus of the first goal gets built into the risk profile of the asset allocation portfolio and can end up dominating the entire thing. The skewing of the asset mix toward achieving the near-term goal has resulted in an unnecessarily conservative allocation, potentially making it harder to meet later goals as effectively as possible. And unlike with traditional investing, where success or failure is generally measured against a market benchmark, goals-based investing helps tie the portfolio’s performance to real-life events. This can help investors ignore market noise and stay focused on their personal financial goals amid periods of market volatility.

Goals-based investing isn’t new; it’s essentially a more sophisticated version of the way household finances used to be managed. People would put away money in separate envelopes—perhaps one for rent, one for utility bills, and so on—with anything left over perhaps going into a vacation envelope. Should an unexpected expense crop up, the cost would never be taken from the rent envelope, but could be drawn from the vacation fund if necessary.

Goals-based investing: a targeted allocation

It’s an elegantly simple approach that resonates with many investors. Separating what was one catch-all pool into several goal-oriented buckets, however, requires more work, with asset allocation, monitoring, and reporting necessary for each portfolio. The good news is that with professional support from a trusted private wealth manager, the process can be largely pain free.

Once you’ve decided that a goals-based approach could work for you, your investment counsellor can work with you to understand your personal situation, your financial goals, short-term needs, and those further out (such as estate planning and philanthropic aspirations). Together, you can then attribute a risk level and time horizon to each goal and build the best-suited risk-adjusted portfolios to help you reach your objectives. The result will be personalized distinct portfolios, managed and reported on separately, to help you meet each individual goal.

At the very start of this process, we believe investors should begin by asking themselves several important questions for each goal.

1   What purpose, or purposes, do you have in mind for your savings?

2   At what point and over what time period had you planned to spend your savings?

3   Are you committed to adding to your current savings, and if so, in what way?

4   Can you foresee any need to access your savings prior to your long-term goals, and if so, define how that might look?

5   Do you have any need for income at this time from your investments, and if so, how much and over what time period?

Once you’ve gone through that checklist for each goal with an advisor, you can together come up with a different asset mix for each bucket. Thee advisor can then look at what rate of return you need to achieve your goals. If it's not realistic, yoou may have to spend less—or retire later.

Goal-based investing is a simple approach for high-net-worth investors with specific targets in mind. It allows investors to set risk parameters for goals of varying importance and urgency, measuring success or failure against real-world goals rather than market benchmarks.

Getting the risk/return balance is critical, but it can be done while keeping the overall goals of the investor in mind. Understanding an investor’s unique circumstances and financial goals is the key to long-term financial success, but keep in mind that circumstances and goals are dynamic and need to be revisited regularly as the market continues to move up and down.