By Jeff DeAngelis, former chief investment officer of Northwestern Mutual Wealth Management Company.
When it came to managing the family’s finances, grandma may have been on to something. Rather than paying all the bills from one “pot,” she organized her monthly budget in categories and then literally into coffee cans. Grocery money went into one can, rent in another and entertainment in a third.
The system not only made it easy for the family to track their money; it also forced them to make decisions. If there wasn’t enough set aside in one category, they could postpone or reduce spending in another category, or they could take money from another can to cover the cost, thus reducing the amount that could be spent on something else. But at the end of the month, if they stuck with the system, they remained out of debt and on solid financial footing.
Today, behavioral finance is proving the wisdom of grandma’s coffee-can finance—especially as it relates to goals-based investing.
Planning in Buckets
Traditionally, investors have used asset allocation to meet investment goals by combining different assets into a single portfolio that is then optimized to provide the highest possible return for a given level of risk. In this instance, success is generally measured by how well that portfolio performs relative to a market benchmark and certain measures of volatility. While this approach has proven to be very effective in helping to maximize the risk-return relationship of a portfolio, it can make it challenging for investors to measure progress toward their goals.
Goals-based investing recognizes that investors have multiple, and sometimes conflicting, goals. Rather than thinking about all of your assets as a single portfolio, goals-based investing encourages you to create buckets for your individual goals and then apply a timeframe and risk tolerance to each. In doing so, the focus shifts from tracking your portfolio’s overall performance to providing a better understanding of what needs to be done to meet specific goals and the impact that may have on your asset allocation.
Take the Smiths, for example.
Bucket #1: Paying for College. The Smiths’ son, Billy, is just four years away from college. They’ve set aside $125,000 in a 529 plan, but they’ll need an additional $25,000 in order to cover Billy’s college costs. With only four years left until tuition payments come due, they don’t have a lot of time to recoup market losses.
In order to grow Billy’s college account, the Smiths have a few options. They can invest the funds in an aggressive portfolio designed to earn enough of a return to build his account to $150,000; they can keep the $125,000 in very conservative investments and add $25,000 to Billy’s account using money from another source; or they can invest in a balanced allocation knowing that there may be a shortfall that they’ll have to fund from another bucket.
Bucket #2: The Vacation Home. The Smiths have long dreamed of buying a second home in a warmer climate for their retirement years. With $175,000 already set aside and eight years until they plan on making the purchase, they’ve gotten a good start saving for their $300,000 goal, and they can tolerate a moderate amount of risk to get there. Assuming they add nothing else to this bucket of money, the Smiths calculate they’ll need to earn a nearly 6.8 percent average annual return on their vacation home fund to reach their $300,000 goal—a relatively high rate given the Smiths’ timeframe and risk tolerance. A goals-based strategy helps them put the choices into perspective. They can invest their money for a higher rate of return, recognizing that they may be subjecting their portfolio to a higher level of risk; they can take money slated to meet another goal and put it toward their dream home; or they can consider a less expensive home.
Whether it be saving for college, a vacation home or any other financial goal, goals-based investing helps the Smiths understand what it’ll take for them to get there.
Goals Dictate Risk
The power of a goals-based approach lies in its ability to highlight how realistic a goal is relative to your risk preferences and the investment opportunities available. It also underscores the importance of separating needs and wants. Most investors are willing to assume a higher level of risk in an effort to gain additional potential return with money set aside for a vacation home (a “want”) vs. dollars they’ve set aside for college tuition (a “need”). After all, if the additional risk taken with the money set aside for the vacation house results in losses, the Smiths could always forgo the second home or downsize their plans; but they might not be so quick to let go of plans to fund Billy’s college tuition.
Linking Goals with Success
Grandma really did know best. The simple act of allocating those funds according to the family’s various needs and wants was successful in forcing her and the family to recognize the financial tradeoffs of their decisions.
Similarly, a goals-based investment strategy won’t necessarily result in a return that’s better—or worse—than the return achieved through a traditional asset allocation approach. However, linking buckets of money directly to goals may help you set priorities, remain disciplined and have a much clearer picture of how well you’re progressing toward meeting your goals.
Northwestern Mutual Wealth Management Company is a subsidiary of The Northwestern Mutual Life Insurance Company.
The opinions expressed are those of Jefferson DeAngelis as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Information and opinions are derived from proprietary and non-proprietary sources.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against a loss. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment.
