A Common Sense, Goals-Based, Approach to Your Investment Plan

Adviser Massi De Santis explains how to create balance in your portfolio by understanding your goals and priorities.
Author:
Publish date:

By Massi De Santis, Ph.D.

Stocks and bonds make the foundation of most investor’s portfolios. Most investors intuitively understand that the split between stocks and bonds represents the risk-return tradeoff they are willing to make with their savings. A higher allocation to stocks means potentially higher returns but also a greater risk of large losses.

Masso De Santis

Massi De Santis, Ph.D., CFP

But what is the best way to make the tradeoff in practice? The answer starts from the reason you are saving in the first place: to help you fund future goals. So your goals and priorities should be guiding how you balance the tradeoff. You may be willing to take more risk for a goal if you have some flexibility in terms of time horizon or dollar value, or have the ability to make up for potential losses with additional savings down the road. If you don’t have the flexibility, you can’t take too much risk, and you should focus on saving more from the start. The point here is that the goal priority, time horizon, and your saving capacity should all inform how much risk you should take.

Goals and Risk Taking

Assume you are 45 years old with the following goals: You want to save for a down-payment on your first home in two years, your child’s college education in 10 years, and your retirement in 25 years. How should you invest your savings? The short horizon and the importance of making the down-payment on your home mean you should take very little or no risk with the savings devoted to this goal.

In contrast, your retirement goal allows for much more flexibility. First, you’ll be funding most of this goal with future planned savings. This means that short term fluctuations in your retirement portfolio have less impact on your ability to achieve the goal. Second, you may also have flexibility in terms of future savings, retirement age, and planned spending. As a result, the retirement goal allows for a relatively high allocation to risky (and potentially higher return) assets like stocks.

Your child’s education goal is high priority with a 10-year horizon. Where it stands on the risk-return scale may depend on your particular situation. However, we can think of it as being between the other two goals. A moderate allocation to stocks is likely consistent with this goal.

Your goals give you a natural starting point for your allocation to stocks and bonds.

Goals, Time Horizon, and Risk

The example above suggests that every goal should have a different mix of stocks and bonds which depends on the type of goals, their priority, and their time horizon. Taken in isolation, the stocks vs. bonds mix across all your investments, which is what most investors focus on, is not a meaningful number.

We can categorize most goals along the following categories.

Type of Goals

Cash Reserve

Safety Net

Large Purchase

Education

Retirement

Wealth Management

The first two goals are short term goals. The cash reserve contains savings for large ticket expenses that you have planned over the next 1-12 months. Kitchen renovations, or a planned surgery that requires out-of-pocket payments are some examples. You don’t want to take any risk with funds in your cash reserve, so a savings account, preferably high-yield and FDIC insured, can be an appropriate investment. The safety net contains savings for unexpected expenses, like the loss of a job or a major home repair you did not plan for. You can’t take risks with your safety net, so the asset allocation has to be conservative and focused on short term bonds. If you include a buffer, you can include a broad stock index, up to 15% of your safety net. The safety net is a key goal for most plans.

For the other goals, your asset allocation is highly dependent on your time horizon. A large purchase is like the down payment example above. Your goal has a relatively defined amount and time horizon, and it’s usually one single payment from your portfolio. The retirement goal is typically of a much longer horizon and the nest egg is usually withdrawn over long periods of time. The education goal is similar to a large purchase, but the payments will go out in a number of years. Finally, we include a wealth management goal for situations that don’t naturally fit the other categories. This can include a legacy or endowment goal, a “play” account, or uncertain situations where clearer goals will be defined at a future date.

Revising and Adapting Your Strategy over Time

This strategy adapts to your goals over time. As your goals, priorities, and horizon change over time, revisiting the process naturally updates your asset allocation. Even if your goals and priorities do not change, your horizon gets shorter every year, which means the allocation across your goals should become more and more conservative. Typically, horizons of 20 or more years can justify a heavy allocation to stocks, like 80%-90%. For high priority goals with short horizons, in contrast, the allocation to equities should be minimal. Goals that allow for some flexibility and have horizons of at least 5-7 years can justify moderate exposure to stocks.

The figure below shows how asset allocation can evolve over time for the retirement goal and the large purchase goal. This type of chart is called a glidepath. The key difference between the two is in the level of asset allocation when the horizon is near zero, the so-called landing point. For many ‘wealth’ goals, assets are fully liquidated at the end of the horizon to fund the goals, so the portfolio is fully invested in cash and short term bonds at the end. For retirement, the goal is to generate income from the portfolio for many years, which is enhanced by a moderate exposure to stocks. So the landing point of the retirement goal includes stocks.

Time Horizon and Allocation to Stocks

Source: DESMO Wealth Advisors, LLC. For illustrative purposes only.

Source: DESMO Wealth Advisors, LLC. For illustrative purposes only.

Other goals can be thought of as intermediate versions or combinations of these. The college goal is similar to the large purchase. The general wealth purchase may be more similar to the retirement glidepath, where a gradual transition to a moderate stock allocation may be consistent with various goals.

The illustration doesn’t mean that the allocation for your own goals will follow a steady glidepath. Your goals, priorities, and horizon can all change. So your allocation will have its own evolution. The key is to revise your plan at regular intervals, like every 6 months to a year, to make sure your investment plan is in sync with your goals.

Your Preferences and Flexibility Matter, too

While the horizon plays a key role in determining your investment guidelines, other things matter as well, so your ideal glidepath may be higher or lower than the ones above.

Your psychological preferences for risk matter. Do short term movements in the value of your savings affect you emotionally? Are they a source of anxiety? How would you feel if your investments lost 25% or more of their value? Consider taking a free risk assessment from the University of Missouri to understand how you think about questions such as these.

Your flexibility matters, too. All else being equal, you can take more risk if you can delay your goals. You can also take more risk if you have the ability to make up for potential shortfalls with additional savings down the road. And you can take more risk if you are willing to settle for a lower-than-planned result if returns are lower than expected. For each goal, consider your preferences and flexibility to fine tune the allocation to stocks.

Because goals are the reason for your savings and investment plan, it is only natural that they should form the basis of your allocation to stocks and bonds. Use your goals, priorities, and investment horizon to develop an allocation for each one of them. Then use your preferences and flexibility to finetune your allocations. This approach increases clarity about the risks that you are taking with your savings, and automatically adapts to your situation over time, so your investments are always in sync with your goals. Get started today!

About the author: Massi De Santis, Ph.D., CFP®

Massi De Santis is an Austin, TX, fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only fiduciary and independent financial advisor, Massi De Santis is never paid a commission of any kind and has a legal obligation to provide unbiased and trustworthy financial advice.