The importance of goal-based investing

By Ravi Samalad |  22-09-17 | 

Traditionally, most investors invest without any planning. When you get a bonus or inherited wealth, you would invest somewhere with the goal of just ‘saving’.

While saving is good, not attaching a goal to investing is bad. It is akin to boarding a train without knowing your destination.

To reach your destination, you ought to have a reason attached to investment which will help you plan your finances well. Why is it important?

Studies have found that planning helps investors generate more wealth. A report from David Blanchett, head of retirement research for Morningstar Investment Management, finds that goals-based planning can lead to a 15 percent increase in utility-adjusted wealth when compared to a traditional approach to financial planning.

Let’s look at one example of how lack of planning can lead us to make bad financial decisions. Assume you invested your Rs 2 lakh bonus received from your company in a mutual fund.

After a few months, you see your neighbour driving a brand-new sedan which leaves you envious. You decide to buy a car and end up withdrawing from the MF investment to make the car’s down payment.

To fund the remaining amount, you apply for a car loan which means you keep paying EMIs till you actually own the car. The expenses keep increasing with insurance, fitting interiors, music system and ongoing fuel costs.

In this enthusiasm to compete with your neighbour, you forgot you had to pay a fee for enrolling in an MBA program. Such mistakes are common. But, how can we avoid making such emotional decisions?

Here are some useful pointers to priorities and achieve your goals. 

Plan for emergencies

Before listing your goals, you would do well to accumulate an emergency fund, which you can dip into in the unfortunate event of job loss or any income source. A thumb rule for building an emergency fund is having a buffer of six months equivalent of your expenses.

It is advisable that you don’t utilise this corpus for any other purpose unless it’s an emergency. Other emergencies like accident, illness or the unfortunate demise of a sole earning family member can leave the dependents in a financial turmoil.

To plan for such emergencies, ensure that you have adequate health insurance cover and life insurance, preferably a term plan. Thus, having an emergency corpus and adequate health and life cover should take precedence before you put down your goals.

Identifying goals

A simple task of writing down your goals (short term 0-1 year, mid-term up to 5 years and long-term 10 years and more) and calculating how much corpus would be required to meet these goals can work wonders.

You may have several goals but prioritising them can help you plan for the most important goals. For instance, prepaying personal loan should take priority over taking an overseas holiday.

Also, your goals should be SMART (Specific, Measurable, Attainable, Realistic and Time Bound). For instance, “I wish to accumulate Rs 10 lakh by 2025 to fund my higher education” is an example of SMART goal over an ambiguous goal like “I wish to be successful in life.” Since life is uncertain and evolving, your priorities and goals will change.

Hence, you should work with your financial adviser to revisit your goals, say annually, to update for any major life changes.

Here is an example of planning for a mid-term goal. Assuming the current cost of funding your daughter’s marriage is Rs 5 lakh. If she decides to marry after five years, you would require Rs. 6.38 lakh, assuming an inflation rate of 5 percent.

Assuming you invest in an open-end equity mutual fund which generates 15 percent CAGR, you would be required to invest Rs 7,100 every month for five years which can generate a corpus of Rs 6.38 lakh.

There are many online calculators which can help you perform this calculation. You can also consult a financial adviser who can assist you in doing goal-based planning. Goal-based investing starts with planning. Products, asset allocation, and returns come later.

When you are investing to attain goals, especially long term, you should avoid looking at short-term performance and instead measure how far have you reached to realize your goal.

The risk-return trade-off 

If you prefer safety, you would realize that you will be required to invest in a product which offers higher returns than FDs to a meet long-term goal like retirement. Since NPS and mutual funds are market-linked products, you should be willing to take some risk to achieve your long-term goal.

On the other hand, it is advisable to go for low-risk products which offer safety when you are saving for a short-term (up to 1-year timeframe goal) even if you are willing to take the risk.

What’s in a name? 

Some players have come up with solution-based products like retirement, child education, etc. to nudge people save for various goals. It is not necessary that you have to invest in a solution based product to meet that specific goal unless it is a Mediclaim policy or life insurance.

For instance, investing in a child plan to accumulate a corpus for your kid’s higher education. Such goal based funds come with a lock-in period which means you will be charged a certain percentage of exit load, a charge levied for early withdrawal.

The purpose of the exit load charge is to deter investors from making an early withdrawal so that they meet their goals. Apart from these cosmetic changes, such funds do not offer any meaningful differentiation in the portfolio which will help achieve your goal. Rather, you may invest in any other open end diversified fund which comes with a good track record.

Reaching near your goal

When you reach your goal, you should start shifting your target corpus to safer assets. For instance, if you have invested in a diversified equity fund for a long-term goal, you can switch your corpus to liquid or debt funds as you approach your goal.

Since equity funds invest in markets, any correction in the market would risk your portfolio and thereby your goal. To sum up, goal-based investing involves these important five steps:

1) Identify and prioritize goals

2) Identify the resources required to meet goals

3) Decide asset allocation

4) Choose the right investments/products

5) Review and revisit goals.

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