Grandma Knew Best: The Advantage of Goals-Based Investing 

Northwestern Mutual Wealth Management Company

Trying to figure out the best way to invest for your important goals? A "bucket" approach, or what's commonly called "goals-based investing" may provide a simple and effective solution.

Think back several decades to your grandmother’s time. When it came to managing the family’s finances, grandma had the right idea. Rather than paying all the bills from one “pot,” she organized her monthly budget by categories. Grocery money in one coffee can, clothing budget in another, rent in a third can and entertainment in a fourth.

By literally dividing the family’s monthly income into different cans, according to needs and wants, grandma helped to keep the family out of debt and on sound financial footing. That’s because grandma’s system made it easy for the family to track their money. It also forced them to realize that if there wasn’t enough set aside in the can marked “clothes,” for example, they had two choices: they could postpone or reduce spending on new clothing, or they could take money from another can to cover the cost of new outfits, thus reducing the amount that could be spent on something else such as food or rent.

Now fast forward several decades. Today, the field of behavioral finance is proving the wisdom of grandma’s coffee-can finance, specifically as it relates to what’s called “goals-based investing.”

Planning in Buckets

Traditionally, investors have used asset allocation to meet investment goals by combining different assets into a single portfolio that is then optimized to provide the highest possible return for a given level of risk. In this instance, success is generally measured by how well that portfolio performs relative to a market benchmark and by using statistics like standard deviation to describe how volatile the portfolio may be.

While this approach has proven to be very effective in helping to maximize the risk-return relationship of a portfolio, it can make it challenging for investors to measure how well they’re doing toward achieving specific goals. That’s because behavioral researchers have found that most people don’t think about their money as one large “lump.” Rather, they use mental accounting to separate it into buckets based on different goals and other criteria. What’s more, studies also show that when it comes to risk, investors focus on the likelihood of losing money (thus not reaching their goal), rather than on whether their portfolio beat the market overall.

Many Goals, Many Buckets

Behavioral finance tells us that your feelings about how much risk you’re willing to accept in relation to the money you’ve set aside for one goal may be very different from your feelings about risk related to another goal.

Goals-based investing recognizes that investors have multiple and sometimes conflicting goals. So rather than thinking about all of your assets as a single portfolio, goals-based investing encourages you to create buckets for your individual goals and then apply a timeframe and risk tolerance to each. In doing so, goals-based investing shifts the focus from tracking your portfolio’s overall performance to providing a better understanding of what needs to be done to meet specific goals and the impact that may have on your asset allocation.

To be clear, goals-based investing doesn’t provide a performance advantage over a traditional asset allocation strategy, and many investors are comfortable investing for all their financial goals through a single portfolio. But for those investors who are looking for a way to more directly align their assets with their needs and wants, goals-based investing provides certain advantages. Like grandma’s coffee can approach, goals-based investing forces investors to separate and prioritize their goals and, in doing so, makes it easy for them to track their progress along the way. No matter what approach you take, just remember that no investment strategy can guarantee a profit or protect against loss.

To understand how goals-based investing might work for you, consider the following hypothetical examples:

Bucket 1: Paying for a Child’s College

Wayne and Karen Reyer, both age 55, have three children. Their youngest son, David, is just entering his freshman year of high school. With college just four years off, and their own retirement not far behind, Wayne and Karen have set aside nearly $200,000 in a 529 plan. In speaking with their wealth management advisor, the Reyers have determined they will need an additional $50,000 over the next four to eight years in order to cover David’s total college costs.

Wayne and Karen opened their son’s 529 savings plan the year he was born. At the time, they indicated a moderately high level of risk tolerance, which made sense given their longer timeframe. Now David’s high school graduation is on the horizon, and the Reyers feel differently about the level of risk they’re willing to take in order to build David’s college account going forward. It makes sense: with only four years left until they need to start making tuition payments, the Reyers don’t have a lot of time to recoup any market-related losses.

A goals-based investing approach can help. In order to grow David’s college account from its current $200,000 to $250,000, the Reyers have three choices. Like our example of grandma’s coffee-can finance, they can invest David’s account in an aggressive portfolio designed to earn a level of return sufficient to build his account to $250,000, they can keep the $200,000 in very conservative investments and add $50,000 to David’s account over the next several years using money from another source, or they can invest in a balanced allocation knowing that there may be a shortfall that they will have to fund from another bucket . Either way, goals-based investing helps the Reyers understand what it will take for them to reach their goal.

Bucket 2: Funding Retirement

Wayne and Karen have saved diligently and want to retire in the next few years. Together they have a portfolio of $2 million in various 401(k) and IRA accounts. More than half of their portfolio is currently allocated to the company stock of Wayne’s employer.

The Reyers have set a goal to use these savings to supplement the pension Wayne will be entitled to once he retires plus their respective Social Security benefits. Working with their wealth management advisor, the Reyers determine a withdrawal rate that they agree is sustainable for the duration of their retirement. Because they are likely to be retired for 30 years or longer, they want to be sure their money also has growth potential to keep pace with the rising cost of living. As a result, they’d like to see their portfolio perform slightly better than the rate of inflation while also producing income. When it comes to their retirement funds, Wayne and Karen describe their risk tolerance as low. What investment strategy would be appropriate to help the Reyers meet their goals?

A goals-based investment strategy makes it easy to create a risk-appropriate solution for their retirement needs. It begins by identifying a balanced approach that will diversify the Reyers’ overly concentrated portfolio of company stock. This should help answer the Reyers need for liquidity to meet their cash flow needs in retirement. Creating a well-diversified portfolio will also help mitigate the likelihood that a downturn in the value of the company stock will prevent the Reyers’ portfolio from achieving their desired minimum average return and help ensure the portfolio has the growth potential needed to keep pace with inflation over time.

Bucket 3: Purchasing a Vacation Home

One of Wayne and Karen’s dreams has been to buy a second home in a warmer climate, where they can go to escape the cold winters once they retire. They estimate that the type of home they’d like to own will cost approximately $1 million.

The Reyers have gotten a good start saving for this goal. With $600,000 already set aside and eight years until they plan on making the purchase, the couple can tolerate a moderate amount of risk to reach their goal. How should they invest their money?

Assuming they add nothing else to this bucket of money, the Reyers’ wealth management advisor calculates that they will need to earn a 6.6% average annual return on their vacation home fund to reach their $1 million goal—a relatively high rate of return given the Reyers’ timeframe and stated risk tolerance. A goals-based strategy helps the Reyers to put their choices into perspective. They can move forward and invest their money for a higher rate of return, recognizing that they may be subjecting their portfolio to a higher level of risk; they can take money slated to meet another goal and put it toward their dream home; or they can consider looking for a less expensive vacation house.

Getting Real About Risk

The power of a goals-based approach lies in its ability to highlight how realistic a goal is relative to your risk preferences and the investment opportunities that are available. It also underscores the importance of separating your goals according to whether they are needs or wants.

Prioritizing your goals is crucial to investment success because it recognizes that setting aside one bucket to buy a vacation home in retirement is likely to have a very different risk profile than money you set aside to cover everyday expenses in retirement. After considering their options, the Reyers decided to move forward with their vacation home plans, accepting the fact that they are taking on a higher level of risk in the hopes of achieving a higher level of return on this particular pot of money.

Most investors would be willing to assume a higher level of risk in an effort to gain additional potential return with money set aside in a vacation home bucket vs. funds they’ve set aside for a child’s college tuition or to cover living expenses in retirement. That’s because the vacation home is a want while living expenses are a need. If the additional risk taken with the money set aside for the vacation house results in losses, you could always forgo the second home or downsize your plans; however, you might not be able to cut back on essentials, such as food, medical or other expenses, needed to maintain your standard of living if you took that same risk with your retirement bucket.

Linking Goals with Success

Grandma really did know best. While the money she tucked into coffee cans each month wasn’t being invested per se, the simple act of allocating those funds according to needs and wants forced her and the family to recognize certain financial tradeoffs that might not have been obvious had all the money been lumped into one can.

In the same way, a goals-based investment strategy won’t necessarily result in a return that’s better - or worse - than the return achieved through a traditional asset allocation approach. However, linking buckets of money directly to goals may help you set priorities, remain disciplined in the face of competing demands on your money and have a much clearer picture of how well you’re progressing toward meeting your goals.

Prioritizing Financial Goals

prioritizing financial goals