It’s common knowledge that investing in the share market is a great way to get ahead financially. But before you put on your investment hat, ask yourself one question – “What exactly am I saving and investing for?” In this blog, Director & CEO of ProAdviser, Nikhil Sreedhar reveals the importance of having a clearly defined goal for investing success:
Goal based investing is not some pseudo, new age way to manage your investment account – it is necessary for maximising the outcomes of investments, including when you can afford to sell down assets and spend on your goals.
For those who are new to goal-based wealth management, goals allow you to bucket your money according to its purpose.
Goal based investing stems from the “envelope system” a decades old savings strategy where every payday you peel off a little cash and deposit it in your envelopes, slowly chipping away at your goals.
Below are some of the behavioural and financial reasons why goal-based investing works:
1. You’ll avoid under saving
Once you have committed to a goal it forces you to think about it more often and far in advance. It prevents you from underestimating how much money you’ll need at any point in the future – or misaligning your expectations with your savings and investing ability. It means that present-day you and future you have more in common ground.
2. The market will grow your savings for you
Once you couple a savings plan with a well constructed investment strategy, over time you will actually have to save less than you originally intended to. Why? The power of compound returns. The earlier you start goal based investing, the more time you give the markets to grow your savings for you.
For example, imagine that you want to go on a holiday – let’s say you need $40,000 for a luxury European escape for your 10th wedding anniversary. Being smart you are not going to finance this on a personal loan (as you’ll pay bucket loads of interest), but rather you’ll save up ahead of time.
If you save monthly for one year, you’re essentially going to save dollar for dollar for your holiday. But if you start your savings plan 5 years out and put the money into an investment account you physically only need to save $32,332.54 (or $538.88 per month). The remaining amount of $7,667.46 will be earned for you by the market.
3. You’ll receive data driven recommendations
Investment markets are volatile and each market can move at different rates due to different factors. Goal based investing is a hands on approach that is focused on achieving the outcome. Therefore, when markets deliver strong returns, the monthly savings plan can be altered, as over time the market will do the hard work for you. However, if markets fall, monthly top ups will have to be increased so that the goal can still be achieved.
These changes can be calculated using the Future Value Annuity Formula or can be recommended to you on the go via an automated service like ProAdviser.
4. There will be tangible outcomes
According to behavioural psychology the ‘Affect’ concept comes into play when we are motivated by real things, as opposed to abstract balances.
With goal based investing, each goal has to be tangible and preferably something that you can visualise – eg. car, boat, holiday or retirement lifestyle. When you can attach a real outcome to the purpose of your saving, you’re more likely to actually work toward that goal rather than blind saving.
5. You’ll enjoy guilt free spending
Myself included, it is not uncommon, for people to feel guilty and even uncomfortable about spending large amounts money. This feeling is more likely to occur to those that save for a big ticket item out of a general savings account, even if it was a planned expenditure.
With goal based investing when it comes time to spend your savings, if it comes from an account specifically earmarked for that purpose, you’re not overspending. Goals also mean you’re more likely to only spend the amount saved in the goal, rather than scooping out a lump sum from a general savings account.
6. You can set up regular investment deposits
For many people it is far more practical to save a nominal amount like $200 per week, or $800 per month rather than a lump sum deposit of $10,000 per year. This style of regular investing is not only practical but also a great investment strategy. Why? The power of compound returns of course!
Firstly, it allows for dollar-cost averaging, which reduces the diversifies of your cost-basis entry points over time compared to a lump-sum purchase. Secondly it maximises the amount of time your money spends invested in the market. These investment practices can improve your returns and your tax bill over time.
7. Goals turn weaknesses into strengths
Goal based investing harnesses another concept in behavioural finance called “mental accounting”. In essence it means as investors we make specific decisions for each investment account, rather than viewing them as aggregated. By creating a mental account for each goal, you ensure that you optimally grow each of them – and do not rely on one to cover any future liabilities.
8. You’ll better manage your cash flows and avoid expensive debt
Goal based investing allows you to close the gap between the money you can afford to spend and the money you want to spend. By clearly matching the cash inflows of today to the cash out flows of the future, you can ensure you don’t go into debt for the wrong reasons.
The last thing you would want, is to accumulate large amounts of debt for expenses that could have been managed such as a holiday or car.
9. You’ll achieve optimal investment returns
Goal based investing matches your investment horizon to your asset allocation, which in non-financial words means you invest in safer assets. When you get this wrong, it can mean missing your goal because you invested in risky assets and they ended up losing value.
– Goals make it far more likely you’ll save for each goal in advance – which makes you more likely to achieve them.
– Goal based investing allows investors to improve returns and be tax efficient in the long run.
– Goals with sound investment strategies, reduces the overall risk of your portfolio helping you achieve higher risk adjusted return.