Most of the financial industry is geared towards selling products. You answer a risk questionnaire to put you onto the risk spectrum from very conservative to very aggressive, regardless of what you are saving for. All of your assets may be combined into a single plan that is optimized to hopefully provide the highest level of return for a given level of risk, often defined as standard deviation. Unfortunately the average investor would not define risk as the standard deviation, but as not meeting their goal (sometimes called shortfall risk).
What is Goals-based Investing?
A better approach is to ask what are you saving for? and when do you want to get there? Rather than combining all of your assets into one pool, goals-based investing creates separate buckets, similar to how you would when creating a saving/spending plan. In this framework, the focus is on taking just enough risk to achieve the specified goal. And not trying to beat the stock market or market index – your benchmark is your goal not the market.
The more specifically you can define your goals and the time frame, the better. Once you have defined your goal and determined when you want to reach it, you create a plan on how to achieve your goal in that time frame.
Why setting goals works
Setting your own specific goals and having your own plan helps keep you motivated to actually reach those goals. By regularly tracking your progress you are more likely to take ownership and follow through on your goals. By focusing only on your goals (and not those of other people), it helps to reduce the tendency to focus on what the market and other people are doing and also helps avoid making irrational investment decisions that many people do.
Where to start
Start by determining how much you are able to save and with what frequency (weekly, bi-weekly, monthly, etc.). Unless the total amount of savings equals your financial goal, then you will need to invest the amounts you are saving in something other than a bank account. If you have a large rate of savings relative to your goal, you are unlikely to need a high rate of return (and a high level of risk) on those savings to reach your goal. Conversely, you may need a high rate of return if your rate of savings is low. If you determine that an unrealistically high rate of return is needed to achieve your financial goal as you have defined it, you may need to consider adjusting the time frame, rate of savings or the goal itself.
An Example
You welcomed your first child in January and now you are seeing ads for RESPs everywhere. You would like your child to be able to go to university 18 years from now and you would like to be able to help them out with at least some of the costs. Let’s say you want to have $60,000 for your child when they start university in September 2032.
If you had $21,262.31 available today (maybe your baby has very generous grandparents!), you could put it into a diversified investment portfolio that is targeting 6% per year. By September 2032, that investment would be worth $60,000.
If you’re not lucky enough to have that lump sum to invest today, then you would need to come up with a saving plan. Assuming you can put $218.94 into that same diversified portfolio at the start of every month, you would have $60,000 in September 2032.
Where to hold it?
Since this investment is associated with education, the best place to hold it would be in an RESP to take advantage of the Canada Education Savings Grant (CESG) and tax sheltering. You could hold it in a TFSA to tax shelter it, but it would not be eligible for the CESG. The worst possible place to hold it would be a non-registered account. Note that the above calculations do not factor in the CESG, so you would actually need to invest less to arrive at the $60,000 target.
Step by Step
- Identify goal and time frame
- Determine cash available to assign to goal
- Determine rate of return needed when combined with anticipated savings rate
- Choose investments (savings account, GIC, ETFs, stocks, bonds, etc.)
- Choose where to hold investments (in RRSP/TFSA/RESP/non-registered)
- Regularly track progress towards achieving goal
- Adjust savings rate if needed or desired
Need to Have vs. Nice to Have
Once you have identified your financial goals, you can prioritize them in terms of Need To Have (like paying living expenses) and Nice To Have (like buying a vacation home). The investments allocated to your Need To Have goals can then be managed more conservatively than those allocated to your Nice To Have goals, reducing the chance that your basic needs are not met. After a year or two you may have new goals that replace or take priority over the ones you initially set. Maybe you got a raise and are able to save more of your paycheques; you can easily adjust how much of your savings is allocated to each of your financial goals.
