How to invest to achieve your goals?

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Today – Talk about goals based investment – setting up buckets of investment allocations to meet needs

Approaches to portfolio construction

three common approaches in building the framework of a client’s investment solution:

1. traditional (asset-only) or liability approach,
2. Today – goals-based investment (GBI) approach.

The traditional, asset-only approach to investing is based on the seminal work of modern portfolio theory (MPT) – 1952

1. most common approach – build optimal asset allocations for investors based on their aversion to risk (as measured by investment return volatility).
2. Liability driven – Governments or Insurance companies – meet large payment obligations – need immunised investments for short term funding
   1. cash inflows are likely to match and cover their obligated cash out flows

Goals-based ‘bucket’ approach

1. People have many complex and competing funding needs (e.g. living expenses, children’s education, health costs, holidays)
2. To aim to achieve these – GBI shares traits with both LDI and MPT
   1. LDI, which seeks to ‘match’ the characteristics of liabilities (e.g. interest and principal repayments, inflation-linked payments) with a portfolio of investments with similar cash flows, goals-based buckets are established to ‘match’ the characteristics of particular lifestyle objectives with suitable portfolios of investments.
   2. These investments might have similar cash flows as that of the investor’s goals, or they might have correlated risks. As with a traditional approach, which is focused on optimising the risk/return characteristics of a portfolio, the GBI approach can also incorporate mean-variance efficiency at the bucket level.
3. Behavioural factors affecting investors
   1. Traditional investing relies a lot on the rationality of investors – People want to maximise gain while minimising pain
      1. But short-term market corrections can erase all memory of long-term gains = panic sell
      2. regret aversion can lead to pain from not investing more in outperforming asset classes = afraid to invest
   2. GBI lies in trying to account for the non-rationality that occurs as a result of emotional biases and cognitive limitations. In particular, GBI addresses two types of behaviours: (1) loss aversion (emotional) and (2) mental accounting (cognitive).
      1. Loss aversion is the behavioural issue that reveals itself in the risk taking of investors
      2. Mental accounting – investors will create cognitive shortcuts to assist in investing decisions
         1. investor separates and connects different assets with different criteria (e.g. term deposit = emergency fund; CBA shares = child’s university funding), which can lead to irrational decision making

Goal tolerance versus investment risk tolerance

1. Traditional investment theory sets the volatility of investment returns as the key measure of risk
   1. willingness and ability to take on investment risk (or risk aversion) with the expected volatility of diversified portfolios – High vs Low volatility
2. Goal-based investing – the risk tolerance measures are linked to goal characteristics – this is your willingness and ability to take on risk
   1. Tolerance levels are the risk of failing to achieve each of your goals – not the volatility of the investments
   2. Aim of GBI is to maximise your ability to reach your goal – all about having maximum allowable probability meeting goals
   3. volatility of returns is still an important component of portfolio construction, as the risk of not achieving a goal is likely to increase with more volatile investments – but mismatches often occur
3. Examples – see this in risk profiling with clients – some say they are defensive – don’t want loss – but then need to get 8% p.a. plus to get to end FI targets – what is more important? Reaching goals or not seeing short term losses?

The investment process – Setting up Buckets

1. Setting goals – have clear outline of needs for investments
   1. Articulate goals: What is it you want to achieve?
   2. Characterise goals: Clarify the factors – SMART goals – what, when, amounts, etc.
   3. Quantify goals: One you know amounts and timeframes – use characteristics of risk probabilities (e.g. financial security success = 100%) when looking at timeframes
      1. Cash v Shares – Fund renos with shares?
   4. Prioritise goals: Understanding the importance of each goal – rank each in order of importance – don’t take too much risk with short term if it is important
   5. Moderate goals: Solving the economic problems – Limited resources compared to goals can make it impossible to achieve any – look at what you have to work with and where it should go
2. Set goal tolerances and amounts: Once you know the amounts and the timeframes and resources
   1. Set tolerance to loss/risks for each – look at regular commitments or a future one-off funding requirement
   2. The tolerance level might best be expressed as an acceptable level of failure – what is the chance of not achieving goal over the timeframe –
      1. Short term – e.g. Deposit – trying to fund from a few ASX shares to get quick short term gains not a great idea
      2. Long term – FI – Chance of not meeting it goes up if investing that basket in cash assets
   3. Examples – Non-negotiable commitments (ongoing living expenses or holidays) – loss tolerance of 0% (i.e. no acceptable level of failure), versus funding a child’s education might have a 20% loss tolerance in a 3 to 5 year period

Establishing buckets – different investments for each goal

1. About selecting the right investments that will be used to fund each of your goals
2. each distinct goal is assigned its own bucket of investments
3. The size of each bucket allocation is based on:
   1. the size of the goal
   2. overall goal tolerance (prob. Of meeting goal)
4. Priorities – The portfolio bucket with the highest priority (lowest tolerance) goal will be constructed first
   1. level of assets based on the size of the goal, timing of goal, goal tolerance and expected returns
   2. After that is set – go to next priority and so on
5. Bucket types – Short to surplus ->
6. Over time – Review goals:  portfolios should be reviewed to assess whether any goal tolerances are likely to be at risk –
   1. Long term goals become short term – Example – super account set up for 25 year goal of FI – may be higher growth today but 3 years out from retirement – High growth may not be acceptable

Bucket asset allocation and investment selection

1. How to select the investments that will be used to fund each goal?
2. size of each bucket allocation is based on both the size of the goal, the overall goal tolerance
   1. But other important goal characteristics need to be accounted for – (e.g. liquidity needs, volatility, timeframe, etc).
3. Short to Mid term – Cash and defensive assets – Probability of meeting goals in short term can be luck if invested in volatile investments – short term crash can wipe out your chances
4. Long to surplus – Growth assets like shares and property help to maximise your chances of meeting end targets

From a practical point of view, asset segregation can be either physical (separate accounts for separate buckets) or paper-based (the single account that is segregated for reporting and analysis only).

1. Physical – useful where separate tax-effective accounts are used for different goals (e.g. superannuation for retirement goals, cash account for short-term spending, investment bond for children’s education goals).
2. Paper – similar to SMSFs assets – administered between members and accumulation/pension phases – Pooled
   1. “paper” account might require separate portfolios based on differing risk profiles and liquidity needs.

A bucket approach: pros and cons

1. Bucket approach views Risk aversion as not achieving certain goals, rather than aversion to the volatility of returns.
   1. Risk tolerance is defined in a more objective, quantitative way – but Risk and return are separate elements.
2. Advantages of a bucket approach to investing
   1. Behaviourally aware – GBI’s focus on mental accounting and loss aversion can increase investor satisfaction and comfort, especially during times of market stress – Education around accepting losses for long term gains
   2. Reduced turnover – The cyclical nature of markets can create a feedback loop on risk tolerance in MPT.
      1. Avoids panic sells and can help to reduce turnover or following the crowd

The suitability question

1. Everyone has different life stages, goal funding size, knowledge and experience, existing investments and so on
2. But once you have definable goals – investment objectives can individually be managed through bucket-style approach to investing
3. But if you are only really interested in the long-term performance of their portfolio might be better suited to the traditional approach – but at the risk of not meeting short term goals if you pump all deposit funds into markets – that comes down to short term luck

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