What is Goal-Based Investing?
With the several investment strategies available to us, choosing one that suits your unique investment objectives can be confusing. A goal-based investing approach is one such strategy. It stands out as it focuses directly on your goals, determining the amount of money you need to achieve your financial goals, and then developing an investment plan designed to achieve those goals within a specific timeframe.
Consider consulting with a professional financial advisor who can help you understand whether a goal-based investing approach is right for you. In this article, we will explore the benefits and drawbacks of goal-based investing and some key considerations and strategies for successfully implementing this approach.
How does goal-based investing work?
Goal-based investing considers some critical components of financial planning and devises an investment strategy around them. You may have several goals in life, such as buying a house, accumulating enough funds for your child’s college education, retiring comfortably, repaying your student loans, and more. Each of these goals requires you to save and invest. Goal-based investing refers to saving and investing for distinct goals. This method uses your financial goals as the foundation and builds an investment strategy around them. For instance, if your goal is retirement, you can use retirement-specific investment vehicles, such as the 401(k) retirement account or the Individual Retirement Account (IRA), to prepare for your retirement needs. Likewise, if your goal is to save for a child’s higher education, you can use a 529 education savings account and plan for future college expenses. As you can see, each investment is linked to a specific goal and is used for that goal alone.
The primary principle of goal-based investing is that investments should be tailored to specific financial objectives. For example, someone who wants to save for retirement will have a different investment strategy than someone who wants to save for a down payment on a house. Goal-based investing involves determining your financial goals and designing an investment plan to achieve those goals.
5 steps involved in goal-based investing
1. Evaluate and set financial goals
The first step is to ascertain your financial goals. A lot of people invest their money without having distinct financial goals. This leads to overlapping investments, mindless withdrawals, and confusion about where you exactly stand regarding investment success. Goal-based investing ensures that your goals are met with thoughtful investment and savings. Therefore, it is important to start by determining your goals. Your goals could be something as small as buying a car to something as big as buying a home. It could also include things like being debt-free.
2. Determine the time horizon for your goals
The second step is to determine the time horizon for each financial goal. It is essential to consider when you will need the money and how much time you have to achieve the goal. For instance, you can buy a car within a few months of saving. However, buying a house will take longer. Saving for retirement will require even more time. Allotting a timeline to your goals will help determine the appropriate investment strategy. However, be realistic when you set timelines. If you set out to achieve a goal quickly, you may have to adopt a very aggressive investment strategy, live frugally, and drastically lower your spending. Even with this, you may not always be able to achieve your goals. This ultimately leads to financial stress and can result in poor investment decisions out of panic.
3. Understand your risk appetite
The third step is to determine the level of risk you are willing to take to achieve your goals. You must consider your risk tolerance and ability to tolerate market fluctuations. This will help to determine the appropriate asset allocation for the investment portfolio. The timeline of your goals can help you here. A long-term goal allows you to take on more risk, and the chances of earning a high return are enhanced over time. However, short-term goals may not be able to withstand high market volatility. A financial advisor can help you understand this better.
4. Select the right investments based on the three points mentioned above
The fourth step is to select investments that align with your financial goals, time horizon, and risk tolerance. This may include a combination of stocks, bonds, and other asset classes. The goal is to create a diversified portfolio that will provide the best chance of achieving the financial objectives while minimizing risk. Adding goal-based investments like 401ks, IRAs, health insurance, health savings accounts, 529 education saving accounts, etc., is essential.
5. Monitor your investment portfolio periodically
The final step is to monitor and adjust the investment portfolio as needed. As you progress towards your financial goals, you may need to adjust your investment strategy to ensure it stays on track. This may include rebalancing the portfolio or making changes to the asset allocation. For instance, you may want to lower your stock exposure over time as you move closer to retirement and increase your debt allocation. These decisions can align with your changing risk appetite, altering financial goals, and narrowing your time horizon.
3 benefits of goal-driven investing
Goal-based investing offers several benefits for investors. Some of these can be discussed below:
1. It offers a clear structure and foundation for your investment decisions
When focused on achieving specific financial objectives, you are less likely to make impulsive investment decisions based on short-term market fluctuations. Goal-based investing helps you invest consistently, without diversions towards your goals, until you achieve them. Setting and achieving financial goals can also be very motivating and help you stay committed to your long-term financial plan.
2. It encourages long-term investing, a strategy that has shown high returns historically
Another benefit of goal-based investing is that it encourages a long-term perspective. You are less likely to get caught up in short-term market fluctuations when focused on achieving specific financial objectives. This can help reduce emotional decision-making and improve investment outcomes over time. Historically, markets have performed well over the long term. Hence, you can meet your financial goals with a greater probability.
By focusing on achieving specific financial goals, you may be more likely to achieve better long-term outcomes than simply focusing on maximizing returns or accumulating wealth without a clear purpose.
3. It allows you to track your investments and measure their performance
Goal-based investing provides a framework for measuring investment performance. Traditional investment approaches are often measured by market benchmarks. However, these benchmarks may not align with your specific financial goals. Goal-based investing allows you to measure your investment performance against the specific financial objectives you are trying to achieve. For instance, if you plan to save a million dollars by a certain age, you can measure your growth and success at different ages to track your progress and measure your individual success. Your success will have nothing to do with a benchmark’s performance but whether you achieve your goal without the stated timeline.
2 potential drawbacks of goal-based investing
While goal-based investing offers many benefits, there are also potential drawbacks to consider, as explained below:
1. It can be confusing to keep track of so many financial goals
One potential drawback of goal-based investing is that it may be more complicated than traditional investment approaches. Designing a goal-based investment strategy requires thoroughly understanding your financial goals, risk tolerance, and investment options. Moreover, all of these components are bound to change every few years. Hence, you would need to update your goals and strategies accordingly. This can be a complex process. Any mistakes you make can cost you your goals.
2. It may be hard to monitor your investments
Measuring the performance of your investments against benchmarks you set yourself may not always be accurate. It is essential to look at the market and the growth of your investments with respect to the market to determine your investment success and profits. Achieving your goals may not be the only thing to focus on. You must also aim to earn market-linked and inflation-beating returns.
How to ensure your goal-based investing strategies work
1. Be realistic when setting financial goals
It is essential to be realistic when setting goals. Take a look at your income, wealth, and lifestyle before you set goals. Setting clear and specific financial goals can help you clarify what you want to achieve with your wealth. This can help you make more informed decisions about your investments and other financial matters.
While it is important to have ambitious goals, setting unrealistic or overly optimistic goals can lead to disappointment and frustration and may even make it more challenging to achieve your financial objectives.
2. Break down your goals as short, medium, and long-termBreaking down your goals as short, medium, and long can help you categorize your goals and select suitable investment plans for them. This also allows you to determine the amount of risk you can take for each objective, further determining your returns.
When bifurcating your goals into short, medium, and long, you must also consider the impact of taxation on your returns. Short-term and long-term taxes on capital gains differ. Long-term capital gains are taxed at 0%, 15%, and 20% based on your profits and tax filing status, whereas short-term capital gains are taxed as per your overall income for the year. In the latter’s case, you pay tax according to ordinary tax slabs – 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
3. Take advice from a financial advisor
A financial advisor can play a crucial role in helping you with goal-based investing. The professional can help investors set realistic and achievable financial goals based on their current financial situation, risk tolerance, and investment preferences. They can develop a personalized investment plan designed to achieve your financial goals over the long term with a portfolio that includes a mix of different asset classes, such as stocks, bonds, and cash, tailored to your risk tolerance and investment objectives. A financial advisor can also monitor your progress toward your financial goals and adjust the investment plan as needed to keep them on track.
Additionally, they can educate you on the different investment options available and provide guidance on the best strategies to achieve your financial goals. A financial advisor can also help you manage your emotions during market volatility, preventing you from making impulsive investment decisions that could negatively impact your financial goals.
Goal-based investing can be an effective strategy if you are looking for goal-specific financial growth. However, it is crucial to create an investment plan after understanding your risk appetite and investment horizon. Reviewing your plan and changing your investment portfolio as and when time demands are essential. Also, remember to carefully consider the potential drawbacks of goal-based investing and work with a financial advisor to develop a plan tailored to your individual needs and circumstances.
Wiser Advisor’s free advisor match service can help you find a suitable financial advisor who can provide valuable guidance and support for pursuing a goal-based investment strategy. All you have to do is answer a few simple questions based on your financial needs, and the match tool will help connect you with 1-3 advisors best suited to meet your financial requirements.