The Butler Report

The Case for Goals-Based Investing
06-10-2014

Sudden market downturns cause many people to panic and sell otherwise good investments. Other people feel that they absolutely have to be in on the ground floor of every new emerging market. Goals-based investing addresses these emotional responses to investing.

In a speech titled "The Challenge of Central Banking in a Democratic Society" given at the American Enterprise Institute on December 5, 1996, Alan Greenspan, then Chairman of the Federal Reserve, uttered two words that would make it into the common colloquial speech not only of financial professionals but the general public at large. The two words were irrational exuberance:

But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
- Alan Greenspan, Source: The Federal Reserve Board

It was the midst of the dot-com bubble. Investors had become famous for handing large sums of cash to naive youth for their untested ideas in a heretofore nonexistent market: the Internet. What Mr. Greenspan so rightly alluded to was the emotional wind that was pushing so many investors to abandon their better judgement. He referenced the Japanese who had made some horrible real estate deals around the same time. Their gross overpayment for the purchase of Rockefeller Center is the stuff of legend (read more about it here).

My point is that even the most educated and experienced investors act from their gut more than they'd like to admit, so imagine how difficult it is for the average household retirement investor to avoid irrational exuberance. Goals-based Investing is designed to help you keep a cool head in the game, even during emotional turmoil.

Goals-based Investing centers around a household's capacity for risk versus its tolerance for risk. In other words, instead of asking a family how much risk they're willing to take now, we calculate how much risk they can take over the entire investment period. A couple who wants to retire in ten years will have a different risk profile than a couple looking to retire in 30 years. People naturally tend to want to take more risk when everything looks rosy, but shrink from it when things look bleak. A goals-based approach helps prevent emotional decisions that might be detrimental to the long-term achievement of the goals.

Another aspect of Goals-based Investing is that it takes into account the entirety of one's assets, not just those that are liquid and investable. The full portfolio is considered to include assets such as real estate holdings, Social Security benefits, employment income, pension income, retirement savings accounts, etc. as well as liabilities such as loans, mortgages, dependent children, etc.

A Goals-based strategy might be broken down into short-, medium- and long-term goals. For instance, a six-month reserve of household expenses in an easily accessible account might be one short-term goal, while college tuition might be a medium-term goal with retirement following as a long-term goal. The short-term assets might be held in low-risk, low-yield instruments such a money market fund while the medium-term goals could be leveraged using higher-risk, higher-yield instruments. Depending how far off retirement is, these might represent the highest-risk, highest-yield instruments, but they might not.

Goals-based Investing takes into account various factors that can influence each of these groups positively or negatively. For example, an iron-clad employment contract with a golden parachute clause might reduce the need for an emergency fund. A child's ability to contribute to their own college expenses through substantial earnings, such as being a successful child actor or model, or through scholarships, can reduce the need for a college fund. Finally, ongoing income from assets such as book or music royalties can greatly diminish the need for retirement savings. Conversely, caring for a special needs child in their adult life can increase the need for such savings.

In my next article I'm going to discuss the various behavioral biases that derail many investment strategies that Goals-based Investing can help prevent.

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