Balancing Risk & Time in Goal Based Investing
There is a lot of discussion these days on whether we need to change the way we assess an investor portfolio. Comparing with benchmarks, comparing with category returns, adjusting for inflation – these are all tools for an adviser to steer the course of the portfolio in the right direction. But are these what matters to the investor in the end? With the emergence of goal based investing, a far simpler and truer parameter for investors would be: "Am I making enough returns to meet my goals?"
Goal based investing essentially changes the focus of the entire investing process, localising it to the goal 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 goal based investing has changed risk assessment and portfolio allocation is a great example of this re-alignment. Let's deep dive into that with an investor case study.
The Essence of Time in Goal Based Investing
A goal is essentially an objective or 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 – like, for example, the portfolio created by a fund manager. Being time bound gives investor 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 advisers to 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 8-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.
Their risk assessment questionnaires reveal them to be conservative investors (risk tolerance).
We see one clear investment goal for the Purans.
Goal: Child Education
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% 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 2 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, the investor risk tolerance is low.
Balancing the Scales
As an 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 9.5%* in 10 years; a balanced portfolio would return around 10.25%*; and a moderately aggressive portfolio would return 12.25%*, 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 lakhs instead of a crore, and take an education loan to cover the rest, their required rate of return in 10 years is changed to a little over 11%, 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%, 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 staying within their tolerance limits, the maximum return the portfolio can earn is 10% per annum. Saving Rs. 40,000 a month can then give them Rs. 70.2 lakhs, while saving Rs. 50,000 a month can give them Rs. 87.75 lakhs 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% on the education portfolio for their son!
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