Goal-based investment makes portfolio allocation simpler
How do you assess the health of your investment portfolio? Do you compare your returns with benchmarks or category returns, while adjusting for inflation? These are all tools for an adviser or portfolio manager to steer the course of your assets in the right direction. But how important are market movements for you, as an investor? A far simpler and truer parameter would be: “Am I making enough returns to meet my goals?”
Goal-based investing changes the focus of the entire investing process, making it completely about the target in hand. Right from risk assessment, portfolio allocation, to rebalancing, and assessment, every decision point moves away from generic market parameters to goal-specific ones. Of course, market conditions and outlook are still important to take a call on any portfolio activity – but they are not the sole deciders any more.
How a qualified adviser would perform the risk assessment and asset allocation for your portfolio, with a specific life goal in mind, is a great example of this re-alignment.
Let’s deep-dive into that with an investor case study.
The Essence of Time
An investment goal is a specific financial result that needs to be achieved within a specific time frame. The fact that goal-based portfolios are time-bound is what makes them different from investments that are simply created to generate market-beating returns; for example, the portfolios created by mutual fund managers are meant to be perpetual. Being time-bound gives goal-based portfolios their very own risk capacity, which indicates the amount of volatility the portfolio can afford. This is different from the investor’s own risk tolerance. I may be an aggressive investor, but if I have only 10 years to save for my retirement, can I afford the downside that may come with investing in equity?
Being time-bound also gives goal-based portfolios a target rate of return. As we will see in the following case study, goal-based investing requires that advisers balance all three aspects – an investor’s risk tolerance, the portfolio’s risk capacity and the portfolio’s required rate of return – in a bid to help the investors achieve their goals.
Let’s take the case of a couple, the Purans. They’re both working professionals, around 35 years of age, with a combined investment capacity of around Rs 5 lakhs a year. They have an eight-year-old son, whom they aspire to send to the US for graduate studies. They are both well covered for medical expenses by their companies, and are insured for their lives. If we were to capture their investment needs for an adviser:
Goal: Child education
Risk tolerance: The Purans’ risk assessment profiles reveal them to be conservative investors.
Required rate of return: The Purans have 10 years to save for their son’s graduate studies in the US. They’re working with an assumed target of Rs 1 crore, factoring in inflation. They wish to invest Rs 40000 every month for this goal (Rs 480,000 per annum), meaning that they need an annual return of a little over 16 per cent to meet their goal.
Risk Capacity: We could see the risk capacity parameter as a range, rather than a single point of reference. A 10-year time horizon allows the Purans to take an aggressive stance with the portfolio for this goal. However, as the goal approaches closer, they will need to move the portfolio into purely conservative investments, reducing their risk-taking window by two years.
So, in this case, the risk capacity of the portfolio ranges from very conservative to moderately aggressive, while the target rate of return is very high, and the investors’ risk tolerance is low.
Balancing the Scales
As an unbiased adviser, the first job at hand would be to explain why the couple’s goal is unrealistic. Assuming that a moderately conservative portfolio would return around 9.37 per cent* in 10 years; a balanced portfolio would return around 10.31 per cent*; and a moderately aggressive portfolio would return 12.29 per cent*, the Purans are looking at the following mismatch:
In such a situation, there is no real ‘investment advice’ that can be given for this goal. The investor first needs to be guided on changing parameters in a way that all three parameters can be satisfied. For the Purans, for example, some of the possibilities are:
1.They revise their target downwards. For example, if they decide to target Rs 75 lakh instead of Rs 1 crore, and take an education loan to cover the rest, their required rate of return in 10 years would change to a little over 11 per cent, which falls well within the risk capacity of the portfolio.
2.They increase their monthly savings target for the goal. So, if they decide to invest Rs 50,000 every month instead of Rs 40,000, the target rate of return is just over 12 per cent, which is also within the risk capacity of the portfolio. This will, however, mean that they need to increase their rate of saving and lock in any increase in earnings in the coming years too.
3.Both these options, however, still place the goal outside of their risk tolerance. If they insist on investing close to their tolerance limits, the maximum return the portfolio can earn is 10 per cent annually. Saving Rs 40,000 a month can then give them Rs 70.2 lakh, while saving Rs 50,000 a month can give them Rs 87.75 lakh at this rate of return.
This process of aligning risk, tenure and return can help investors understand that the best investment advice, and the best investment performance cannot exist in a vacuum. They depend on an investors’ own goals and their willingness to stay focused on those goals. If the Purans decide to go in with option 3, all they really need to worry about at the end of every year is whether or not they are earning 10 per cent on the education portfolio for their son!(The writer is Managing Director, iFAST Financial India Pvt Ltd)Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.