Goals-based investing is a means to an end

The “envelope system” is a well-known money-saving strategy.

The idea is to save for your goals—a down payment for a home, a new car, a vacation—using a series of envelopes. Every payday, you peel off a little cash and deposit it in your envelopes, slowly chipping away at your goals.

Things have gotten a little bit more sophisticated over time, but the time-honored envelope system is the same idea behind the growing trend of goals-based investing. In investing parlance, it’s known as “mental accounts,” where each of your financial goals are funded and invested independently. Each goal, because it has a unique time horizon, has its own asset allocation and its own risk profile.


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“The reality is that most of us have multiple risk profiles for multiple goals,” said Jean Brunel, managing principal of Brunel Associates, author of “Goals-Based Wealth Management: An Integrated Approach to Changing the Structure of Wealth Advisory” and a practitioner of goals-based investing since 2004.

Rethinking risk

Financial advisors have been practicing goals-based investing for about 15 years, but the strategy really took off in the wake of the financial crisis, when even the most dedicated investors had a hard time stomaching extreme losses.

Goals-based investing, advisors say, quells nerves because investors can measure the severity of a drop in their portfolios to how it relates to their goals.

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“When you don’t do goals-based investing, you’re kind of anchorless,” said Daniel Egan, director of behavioral finance and investing with online advisor Betterment. “‘I want to have more money in the future’ is not a goal.”

Goals-based investing tries to marry Modern portfolio theory—the foundation of most asset-allocation strategies, first introduced by Nobel Prize laureate and economist Harry Markowitz—with investor behavior.

Modern portfolio theory holds that an optimum portfolio is one that gets the most return for every unit of risk. If it does, it is considered to be on the efficient frontier.

“I can tell you that using goals-based investing makes periods like 2008 incredibly easy to handle.”-Jean Brunel, managing principal of Brunel Associates

“The problem is that most people can’t handle a portfolio that’s on the efficient frontier,” said Jonathan Scheid, president and chief investment officer of Bellatore Financial, which provides portfolio management for financial advisors.

Scheid, along with co-authors Sanjiv Ranjan Das, Markowitz and Meir Statman, co-wrote a paper, “Portfolio Optimization with Mental Accounts,” in the Journal of Financial and Quantitative Analysis in 2008.

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What’s more, modern portfolio theory is not the way that most people understand investing.

“Now when you walk into any financial advisor’s office, they’ll tell you, ‘This is the right asset allocation you,'” said Ashvin Chhabra, chief investment officer at Bank of America’s Merrill Lynch unit and author of the recently published book, “The Aspirational Investor: Taming the Markets to Achieve Your Life’s Goals.”

“What you should be thinking about is, ‘Will my kids go to college?'” he said.

Different goals require different risk profiles. For example, an emergency fund should hardly take on any risk and, in turn, provide very little return. But there’s no fear that its value will drop.

A retirement fund that is not needed for another 30 or 40 years, on the other hand, can tolerate significantly more risk. Investors are less likely to panic and sell at the bottom in the event of a market decline if they are assured that their emergency portfolio has not suffered any declines, practitioners say.

“I can tell you that using goals-based investing makes periods like 2008 incredibly easy to handle,” said Brunel of Brunel Associates.

Goals-based portfolios at work

There are lots of ways to define goals-based investing and many ways to implement it.

Merrill Lynch’s Chhabra, who was the author of an early paper on goals-based investing, “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors,” said most investors have three distinct goals.

First is safety. Second is a market goal, an investment portfolio that’s fully invested to maximize return toward a long-range plan like retirement.

The third is what Chhabra calls an “aspirational” goal, perhaps starting a business or endowing a charity. Investments for this goal may not necessarily be securities. If your goal is starting a business, the portfolio may consist of your human capital and your ability to turn an idea into a profit.

Others define goals-based investing in more concrete ways. At Betterment, for example, investors can break up their accounts into specific goals, such as an emergency fund, retirement, a down payment or a vacation.

But it’s not a matter of setting up three or four different accounts. The different goals, with their own unique asset allocation and time horizon, still work in aggregate. “Your overall portfolio is kind of a reporting layer,” said Scheid of Bellatore.

Investors can also use the aggregate portfolio to limit taxes across the board, noted Egan of Betterment. “When you make a withdrawal from a short-term portfolio, you won’t realize short-term capital gains, because the securities are shared across the account,” he said.

Goals, not benchmarks

Typically, when investors look at their investment statements, they see how their accounts performed against the Standard & Poor’s 500 or another index. But what happens when the S&P falls by 40 percent in just a few short months, though your portfolio drop is only 30 percent?

“People may have beaten the benchmark, but if you were going to retire that next year, but your portfolio lost 30 percent, it’s great that your portfolio outperformed the benchmark, but it doesn’t matter,” said Kevin Barr, vice president of SEI and head of the investment management unit.

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Goals-based investing does not compare returns to a benchmark, Barr said. Instead, the reporting shows the account’s “progress toward goal.”

“At the end of your life, saying ‘I beat the S&P by 3 percent’ doesn’t mean anything,'” said Chhabra at Merrill Lynch. “But if you say, ‘I invested well, I had a nice house, my kids went to a good school,’ that’s something.”

—By Ilana Polyak, special to CNBC.com

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