Goal based investing

What Is Goal-Based Investing?

Goal-based investing is an approach within financial planning where investment decisions are explicitly tied to specific, quantifiable financial objectives rather than focusing solely on overall portfolio performance against a benchmark. Unlike traditional portfolio management that might aim to maximize returns for a given level of risk, goal-based investing structures investments around distinct life events and aspirations, such as purchasing a home, funding a child's college savings, or retirement planning. This strategy helps investors visualize their progress toward each individual investment goal, potentially enhancing discipline and behavioral adherence.

History and Origin

The concept of aligning investments with personal objectives has always been implicit in sound wealth management. However, goal-based investing gained prominence as a distinct methodology in the early 21st century, particularly following the 2008 financial crisis, when investors sought more tangible connections between their savings and their real-world needs. Financial advisors began to formally adopt frameworks that segmented a client's wealth into "buckets" or "sleeves," each assigned to a specific goal and managed with an appropriate investment strategy. This evolution was also influenced by academic research in behavioral finance, which highlighted the psychological benefits of framing investments in terms of specific outcomes rather than abstract returns. For example, research by David Blanchett, Head of Retirement Research at Morningstar Investment Management, has explored how a goals-based framework can lead to an increase in utility-adjusted client wealth by improving investor behavior.⁶

Key Takeaways

• Specific Objectives: Goal-based investing focuses on defined financial goals like a down payment, education, or retirement.
• Tailored Portfolios: Each goal may have a distinct sub-portfolio with an asset allocation strategy aligned with its specific time horizon and risk tolerance.
• Behavioral Benefits: This approach can improve investor discipline by providing clear motivation and visible progress toward meaningful targets.
• Measurable Progress: Investors can more easily track whether they are on track to meet each individual goal, allowing for timely adjustments.

Formula and Calculation

While there isn't a single universal formula for "goal-based investing" itself, the core of this approach involves calculating the required future value for each specific goal and then determining the necessary periodic savings or expected return to reach that value. The future value (FV) of a goal can be calculated using the compound interest formula:

Where:

• (FV) = Future Value (the target amount for the goal)
• (PV) = Present Value (initial investment or current savings towards the goal)
• (r) = Annual interest rate or expected annual rate of return
• (n) = Number of years until the goal needs to be met

Alternatively, if you know the future value and need to calculate the required periodic payment (PMT) to reach it, you can use the future value of an ordinary annuity formula:

Solving for PMT:

These calculations help establish the financial roadmap for each distinct goal, guiding decisions on contribution amounts and appropriate investment strategy for achieving the desired future value.

Interpreting Goal-Based Investing

Interpreting goal-based investing involves assessing whether current savings and investment strategies are sufficient to meet each defined financial objective. It shifts the focus from merely outperforming a market index to achieving specific, tangible outcomes. For instance, an investor isn't just looking for a 7% annual return on their overall portfolio; they are evaluating if their "retirement bucket" is on track to provide a desired income stream by a certain age, or if their "college fund" will cover tuition costs.

This interpretation also emphasizes the importance of aligning the time horizon of a goal with the risk tolerance of its associated investment. Short-term goals, such as a down payment for a house in three years, would typically be funded with lower-risk, highly liquid investments. Long-term goals, like retirement in 30 years, can accommodate higher-risk, growth-oriented assets.⁵ The U.S. Securities and Exchange Commission (SEC) highlights the importance of defining clear goals and understanding your risk tolerance as foundational steps in saving and investing.⁴

Hypothetical Example

Consider Sarah, a 35-year-old professional, who identifies three primary financial goals:

1. Down Payment for a House: $60,000 needed in 5 years.
2. Child's College Education: $150,000 needed in 15 years.
3. Retirement: $1,000,000 needed in 30 years.

Under a goal-based investing approach, Sarah would establish separate "buckets" for each goal:

• House Down Payment Bucket: Given the 5-year time horizon, Sarah allocates a portion of her savings to a conservative portfolio for this goal, perhaps focusing on high-quality bonds and money market funds. She calculates she needs to save approximately $900 per month, assuming a modest 2% annual return.
• College Education Bucket: With a 15-year horizon, this bucket can take on moderate risk. Sarah invests in a diversified portfolio of exchange-traded funds (ETFs) and mutual funds with a balanced mix of stocks and bonds. She estimates needing to save around $500 per month, targeting a 6% annual return.
• Retirement Bucket: For her longest-term goal, Sarah invests in a growth-oriented portfolio, primarily consisting of global equities and real estate investment trusts (REITs). She sets an ambitious savings target of $1,200 per month, anticipating an 8% annual return, leveraging the power of compound interest.

Each year, Sarah reviews the progress of each bucket independently. If the housing market shifts or her child's college plans change, she can adjust that specific bucket's strategy without necessarily impacting her retirement savings plan.

Practical Applications

Goal-based investing is widely applied in various areas of investment management and financial planning:

• Personal Financial Planning: Individuals use this approach to map their savings and investments to life events, from purchasing a car to leaving a legacy. It helps create a clear roadmap for achieving major objectives.³
• Robo-Advisors and Digital Platforms: Many automated investment platforms integrate goal-based investing by prompting users to define specific objectives and then building diversified portfolios tailored to those goals using algorithms.
• Target-Date Funds: These funds are a form of pooled goal-based investing, adjusting their asset allocation to become more conservative as the "target date" (e.g., retirement year) approaches.
• Client-Advisor Relationships: Financial advisors use goal-based investing to engage clients more effectively, making complex investment strategies relatable to their personal aspirations and enhancing client adherence to the plan. Vanguard, for instance, uses advanced models to assist investors in making optimal financial planning decisions based on their goals.²

Limitations and Criticisms

While goal-based investing offers significant advantages, it also has limitations and faces criticisms:

• Sub-optimal Overall Portfolio: A primary criticism is that managing multiple sub-portfolios for different goals can lead to a financially sub-optimal overall portfolio.¹ Traditional modern portfolio theory suggests viewing all assets holistically to achieve the most efficient diversification and risk-adjusted returns across the entire wealth base. Segmenting assets might miss opportunities for synergistic effects or efficient risk management across the aggregate.
• Complexity: For individuals managing their own investments, maintaining separate accounts and strategies for multiple goals can add complexity compared to a single, consolidated portfolio.
• Interdependence of Goals: In reality, financial goals are often interconnected. For example, delaying retirement might impact the ability to fund a grandchild's education. A strict siloed approach in goal-based investing might overlook these interdependencies.
• Behavioral Pitfalls: While intended to improve behavior, the explicit focus on individual goals might lead investors to take undue risks with "stretch" goals or become overly conservative with "must-have" goals, potentially sacrificing overall expected return.

Goal-Based Investing vs. Traditional Portfolio Management

Goal-based investing and traditional portfolio management represent different philosophical approaches to managing financial assets.

The primary confusion arises because both aim to grow wealth. However, goal-based investing differentiates itself by framing investment success in terms of personal milestones rather than abstract market performance. While traditional portfolio management focuses on the overall efficiency of the investment portfolio, goal-based investing prioritizes the successful realization of distinct financial aspirations.

FAQs

What types of goals can goal-based investing address?

Goal-based investing can address a wide range of financial objectives, including short-term goals like saving for a down payment on a house or a major purchase, medium-term goals such as funding a child's education, and long-term goals like retirement planning or leaving an inheritance.

Is goal-based investing suitable for all investors?

Goal-based investing can be beneficial for most investors, particularly those who struggle with staying disciplined or who benefit from seeing their investments tied to tangible life events. It is especially useful for those with multiple, distinct financial objectives that have varying time horizons and risk profiles.

How does goal-based investing impact risk?

In goal-based investing, risk tolerance is often considered on a goal-by-goal basis. For instance, a "must-have" goal with a short time horizon would typically be invested very conservatively, while a "stretch" goal with a longer horizon might take on more risk in pursuit of higher growth. This individualized approach can lead to a more appropriate risk profile for each specific objective.

Can I do goal-based investing myself or do I need an advisor?

While the core concepts of goal-based investing can be applied by individual investors through careful planning and diligent tracking, many choose to work with a financial advisor. Advisors can help define realistic goals, determine appropriate asset allocations for each, and navigate the complexities of tax implications and ongoing portfolio adjustments. Automated platforms and robo-advisors also offer tools to implement a goal-based approach.