For many of us, the purpose of investing is to earn better returns. Nothing wrong with earning higher returns. There is another approach that requires you to set goals/targets and make investments so that you can reach those goals in time. The emphasis is not so much on returns but on ensuring that you have money for your various goals (kids’s education, purchase of house, retirement etc) when you need it.
Which approach is better?
Personally, I like the goal based investing approach better and easier for most investors to relate to (read the disclosure section). In this post, I will discuss how goal based investing or planning can help you.
1. You set a Target
You consider yourself a smart investor or a trader. You have taken some excellent trading or investment calls to outperform the best performing fund by a couple of percentage points. That gives you a high and bragging rights too.
Your investment portfolio has grown from Rs 2 lacs to Rs 5 lacs in 5 years. No doubt you have done quite well.
Is Rs 5 lacs enough? Your next question will be “Enough for what?”
I don’t know. Only you can answer.
What if you were planning to use these funds for retirement? And you need Rs 25 lacs for your retirement. And there are no other funds for retirement.
If I ask the question again, is Rs 5 lacs enough? I am sure you will answer in the negative.
This is where Goal based planning helps. It gives you a target and a context for your investments.
By the way, returns shouldn’t be seen in isolation. You need to view the returns in relation to the risk you undertook to generate such returns. This aspect is ignored by many investors. After all, you can double your money in options trading within a few hours.
Or you can lose the entire capital doing trading in futures. Are your returns in options or futures trading comparable to returns generated through equity fund investing or even a plain vanilla fixed deposit (without considering the risk involved)? The answer is No. However, this is a topic for another post.
2. Return is not Everything
It is merely a part of the equation. Here is the equation of compounding.
FV= Amount X (1+Return)^Time
You can see amount invested and the investment horizon also matters.
You may have done quite well with your tactical calls to generate a return of 15% p.a. However, if you invested only Rs 25,000, you investment would have grown to Rs 50,283 after 5 years. That is a gain of Rs. 25,283.
What if you have opted for goal based planning and you knew that you need Rs 30 lacs for a particular goal in 15 years? You know that you need to invest Rs. 5.48 lacs (one time), assuming a return of 12% p.a. This is way more than Rs 25,000 or Rs 50,000 that you invested.
“I invest Rs 10,000 per month (or any amount) in MF SIPs.” This is a common refrain. Again, what is the context? In absence of a target, it is difficult to tell if it is enough. You may need to make a much higher monthly investment. Assuming a return of 10% p.a., you will end up with Rs 20.6 lacs at the end of 10 years. At 12%, you will end up with Rs 23 lacs. What if you needed Rs 40 lacs?
You are clearly short. You need to invest more. And goal based investing can tell you that. If you were merely focused on high returns, you will probably never realize this.
3. You can prioritize your investments
If you had enough money, you wouldn’t need to prioritize your investments.
Well, that is a luxury not many of us have.
What if you have to invest Rs 10,000 per month for your kids’ education (to reach target corpus) and another Rs 10,000 per month for your foreign vacation after two years?
But you have only Rs 10,000 to invest?
With goal based investing, you can easily that your kids’ education ranks much higher in priority over your foreign vacation?
Hence, this Rs 10,000 will go towards kids’ education.
Goal based investing helps you prioritize your investments.
4. Goals make you think
That you are saving for kids’ education is not enough. You need a target and a time frame too. How do you set the target? Well, you need to think about what and where your kids are going to study. In a way, you will be forced to research.
When you work out your retirement corpus retirement, you will sit and mull over all the potential expenses that you may incur during retirement. I have seen investors in their late 20s with expenses in excess of Rs 50,000 per month have a mental target of Rs 1 or 2 crores for retirement in 30 years. Come on!!! This is clearly not enough. At inflation of 8%, monthly expense of Rs 50,000 will grow to Rs 5 lacs in 30 years.
Therefore, once you get down to working out the numbers, you are forced to think and make your investment plan accordingly.
Don’t forget Goals need to be SMART (specific, measurable, attainable. Realistic and time based).
5. You focus on the end and not the means to reach the end
Money is not an end into itself. It is merely a means to end. When it comes to goals, your focus is on target date and the target amount. How do get there may not be as important? Whether you earn 10% or 15% does not matter as long as you have sufficient funds when you need it.
Therefore, when it comes to goal based investing, you do not target a particular rate of return (or certain minimum outperformance over benchmark). And that takes care of lot of anxiety. You do not have to keep chasing returns and finding the best mutual fund scheme to invest in. So long as you are on target, you shouldn’t care much.
In life, journey may be more important the destination. When it comes to financial planning, destination is way more important than the journey.
6. Helps you with investment discipline
Let’s suppose you do not follow goal based planning and keep a single corpus for everything. You have done a few mental calculations of how much you need for major goals in life. When you need money for anything, you will withdraw from this corpus.
When you are playing around with vague numbers, it becomes quite difficult to assess the impact of such unplanned withdrawals from your investment corpus and the action you need the undo the damage.
However, if you know a particular investment is earmarked for your kids’ education or retirement, wouldn’t you think twice before touching those funds for any other use? Or if you were under some cash flow pressure, wouldn’t these goals be the last for which you stop making investments?
Even if you had to withdraw, you will just redo the numbers (yourself or with the help of your advisor) and make changes to your investment plan.
After working out the numbers for a goal, if you realize you have been investing less than required, you will try to figure out a way to invest more. Goal based investing is intuitive and something you can relate to easily.
If you need money for a goal after 3-4 years, you wouldn’t think much before shifting such funds to low volatility debt products. However, if you were focused on high returns, market conditions may have influenced your decision. For instance, in periods of positive outlook, you may have continued in equity till the very end (and that may be risky).
PersonalFinancePlan Take
There is nothing wrong in targeting high returns. There are a few drawbacks that you need to aware of. I am sure there are many who focus on returns (while keeping an eye on their goals) and do quite well. However, this approach may not work with everyone.
In my opinion, goal based investing approach is easier to understand and relate to. It is easier to review such portfolios and make course correction, if required.
One more point. One fund (or a few funds) for all goals or a different fund for each goal? It is a personal preference. My limited experience tells me that investors are more comfortable and find it easier to relate to when you have different investments for different goals.
What do you focus on? Returns or your Financial Goals?
Disclosure: I have built my practice around financial planning and advise clients on goal based investing. Hence, you can expect my opinion to be biased towards goal based investing.