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I am now ready to do goal-based investing. What now?

Posted on 30 Mar 2021
Author: Sayan Sircar

Tags: Asset Allocation ; Set Goals

13 mins read
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Part 3: I am now ready to do goal-based investing. How do I get started?

Goal-based investing process

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You have now heard of goal-based investing, completed the pre-requisites (see Part 2) and are now finally ready for investing.

📚 Topics covered:

Identify your goals
Step 1: Decide the purpose, horizon and the cost of goal today
Step 2: Assume at what rate the cost of the goal increases yearly
Step 3: Decide how much risk you want to take for any goal
Step 4: Formulate an asset allocation suitable as per assumptions in the previous steps
Step 5: Start SIP in funds as per asset allocation and decide on a review frequency
Step 6: On every review, see if you are on track and manage risk via rebalancing
Important considerations on managing return expectations and portfolio risk

Identify your goals

What are financial goals

Goal-setting is the most fundamental step. Like when you go on a trip, there is a destination; it is the same for any investment. You cannot and should not invest without a goal. Investing without a goal is like getting into a taxi, and when asked, “Where to go?”, you answer “I don’t know, take me somewhere”. You can set goals in many ways:

Sit and think about what you plan for the future: write them down
Discuss with family members since they are important stakeholders for your journey
Major life events like marriage (or not), children (if any), career changes, early retirement (FIRE) etc. will require revision of these goals

Investing without a goal increases the chances of investing in the wrong asset (either too high risk or too low returns), and that will cause problems once you identify actual goals.

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For more details on how to arrive at your goals, please see this detailed post

Step 1: Decide the purpose, horizon and the cost of goal today

Once you have identified the goals, for each goal, note down the

horizon: how far into the future is the goal due: This decides the asset allocation: primarily equity or debt or liquid cash. Asset allocation sets an expectation for the returns you could get and tells you how much to invest in each asset class
present value: how much it costs today: This gives you an idea of how much to save. E.g. ten lakhs for a car, college - 20 lakhs in India, 50 lakhs abroad, five crores for retirement etc.
Priority: how important this goal is to you.

A quick way to classify goals are:

must-have (cannot be missed both in time and amount like retirement)
should have (amount can be flexible like for college education loan can be taken)
could have (these are flexible in both time and amount like a vacation)

You can use this goal-setting framework as well: How to set S.M.A.R.T goals for investing?

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Step 2: Assume at what rate the cost of the goal increases yearly

The concept of inflation applied to the goal: how much do you think the goal will increase in cost every year in the future. It would be best to beat this figure, including the investments you make and the returns you get.

Important: CPI/WPI figures from the government are different from actual inflation applicable to your lifestyle. You should be in a position to calculate the changing cost of your basket of goods and services consumed under major budget heads on a year-on-year basis.

Some inflation assumptions:

For retirement, assume 8-10% inflation and start tracking the price increase of your bucket of goods and services. Add an estimate for travel and health-care (~12%) as well
College education: Foreign countries have low price inflation but high education inflation and will vary from country to country. E.g. UK can have 6% education inflation.
Travel and vehicle purchases are common goals. Assume 8-10% inflation here as well.

Review goals at least yearly to figure out the current prices of your goal (the change since the last review will indicate the inflation)

Step 3: Decide how much risk you want to take for any goal

There are two aspects to risk related to a goal: ability (can take a risk) vs willingness (want to take a risk).

Risk-taking ability: This relatively objective metric shows how much risk can be taken to save for a goal. Factors like high income, less number of dependents, large corpus and high skill-set in career etc., increase the ability to take risks.
Risk-taking willingness: This is a subjective metric that deals with behavioural aspects driven by the level of knowledge about personal finance and experience. Things like buying a house to save tax, keeping money in savings a/c or FD due to distrust/misunderstanding of capital markets (“the stock market is gambling”), gold/real estate is best asset class etc., are typical examples.
Need to take risk: This depends on the goal-priority, corpus target (how much money is needed), horizon, inflation applicable and investible surplus available to be allocated to the goal.

The investor can ascertain both willingness and ability via a questionnaire and discussion. The formulation of asset allocation requires both to be in sync and post-meeting with a competent fee-only planner. By merging the two traits, overall risk classification (per goal based on the need to take risk) can be made using a simple three point scale: high, medium and low.

Here is a detailed post on how to get your risk profile for any goal.

Also read
Does the 4% SWR rule work in India?

Step 4: Formulate an asset allocation suitable as per assumptions in the previous steps

Asset allocation is an important step where you choose the various risky assets that will generate the returns needed for the goal.

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Typically sources of risk include equities, bonds, commodities, real estate and cash. Each has a different risk/return characteristic and, more importantly, interplays with the others depending on how you mix them. This is called asset allocation (AA). Asset allocation is not fixed. Every year you need to review and manage the portfolio glide-path for that goal. The suitable equity: debt mix that you need to have every year is found via risk profiling.

Caveat: while taking risks is needed to generate returns, just taking a high risk does not guarantee high returns. In that case, the risk would be low and not high. Based on this flawed understanding of risk, many new investors go 100% in equity or choose a significant allocation to small-cap funds.

See this detailed post on asset allocation.

Step 5: Start SIP in funds as per asset allocation and decide on a review frequency

There are three steps here:

Choosing the funds:

Choosing funds is the first problem that new investors generally start with, but it is the 5th step in this framework. Many new investors spend the maximum amount of time here. The importance of this particular step (in the overall goal-based investment process being discussed here) is tiny. As long as you have followed the framework being laid down (completing the pre-requisites and setting the goals, you will need to spend very little time in this step)

The following are indicative choices and not recommendations:

Domestic Equity: mostly Index funds (Large cap, mid cap) [(see how to choose an equity index fund)]
International equity: only Index funds
Gold fund (or SGB)
Debt fund: AAA, A1+ or sovereign credit, duration < 1yr plus investments in PPF/EPF/VPF etc. [(see how to choose a debt mutual fund)]

Avoid all ETFs due to liquidity and price/NAV divergence issues: Which are the best and worst ETFs of India?

How to determine SIP amount is covered here: SIP amount for a single goal

Fix the SIP amounts

Based on the return expectation of each of the funds chosen and the asset allocation, you can arrive at a return expectation for the investments as per this post: How much returns should you estimate for your goals?.

See this detailed post for determining the SIP amount once you have the returns.

Decide the review frequency (calendar or corridor)

For calendar method: rebalance every 12 months, six months or quarterly
For corridor method: rebalance whenever weights change by a fixed value, say 5% (e.g. 60:40 will be rebalanced whenever 65:35 or 55:45 happens)

The rebalancing step is critical to managing the portfolio’s risk and allows systematic buying low and selling high. Of course, exit load and capital gains taxes will have to be considered, but these are minor considerations to the benefits that rebalancing brings.

Here is a detailed overview of rebalancing your portfolio.

Step 6: On every review, see if you are on track and manage risk via rebalancing

Ultimately reaching your target corpus for your goal is the only thing that matters: Why you should chase your target goal corpus instead of returns

There are two primary considerations:

Track progress towards goals since the goal increases with time (see Step 2)
Rebalance to manage risk as per price movement

Since markets do not move linearly up like an FD while the value of the goal does, you must keep checking if you are on track. Therefore, you must increase the investment/SIP amount on every review as much as possible.

Review goals regularly

Rebalancing is a highly critical risk management tool to achieve one goal: risk over time needs to reduce as the goal comes closer, typically done by stepwise reducing the equity exposure of the goal.

Allows systematically buying low, selling high
Should be done at the portfolio level (all goals together to minimize trades and taxes)

See this detailed post regarding how to do rebalancing.

See this post for a worked-out example for review.

Important considerations on managing return expectations and portfolio risk

We can have expectations from the market regarding returns (5%, 10%, 15%, 20% or whatnot); however, we will only get what the market gives us. Hence it is essential to manage expectations from day 1 of investing

you should clearly define the goal: horizon, the cost today, inflation and Priority
just by taking lots of risks, there will not be any guaranteed return
investing too little or keeping money lying around in a savings account/FD is dangerous since that money does not beat inflation
expecting too much return from both equity and debt is very risky: chasing returns leads to taking high risk or under-performance
timing the market: selling when the market falls, moving into funds that have recently gone up without a plan, stopping investments thinking the market is ‘overvalued’ all lead to subpar returns
Do not waste time or energy on finding the best stock/fund, best insurance and the best time to invest: You can read more about this here: Investor behaviour: control what is possible

Bottom line: Best process »» best product any day. Next, you will need to document this process as the investment policy statement or IPS. It is the process of investing and creating the IPS as described in this series of 3 posts that give an excellent chance to reach financial goals methodically. Good luck.

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