It is often observed that most investors track their investments very closely but often fail to monitor whether their goals are on track. The reason may be that investments have not been mapped to individual goals. A goal is defined as the purpose for which investments are made. A goal is also associated with a time-frame like a long term goal or a short term goal. Goals may be further segregated by priority as ‘must have goals’ and ‘good to have goals’. The former mostly have a finite time-frame (like your child’s higher education in 10 years, retirement in 20 years) while the latter (like a foreign vacation in 5 years) have a flexible timeframe and can even be excluded if needed.

The Risk Based Approach

Before we discuss the goal based approach, let us understand another approach that many investors follow. This is the ‘risk based approach’. Herein an investor’s investments are treated as a single portfolio and tuned as per his/ her perceived risk-tolerance or risk profile. The investor’s risk profile is based on his attitude towards risk, determined mostly through a questionnaire which includes situational and life-style questions. For example, a risk-averse investor gets a ‘conservative’ risk profile while a risk taking investor gets an ‘aggressive’ risk profile. Intermittent profiles are called ‘moderately conservative’ and ‘moderately aggressive’.

The investor’s portfolio is constructed based on his/ her risk profile irrespective of goals. So a ‘conservative’ risk profile may have a marginal equity component while an ‘aggressive’ risk profile may have a very high equity component. In a risk based approach, goals are met by drawing from this common portfolio. Since you keep drawing from this pool, there is a chance that some goals that are ‘good to have’ but occur earlier in life (like a foreign vacation) may be easily met but those which are a ‘must have’ but come later in life (like retirement) may face a short-fall.

The Goal Based Approach

A goal based approach to investing is thus a more practical approach than a risk based approach as it closely tracks the progress of goals rather than only the investments. It also optimizes the allocation to asset classes based on the time frame of goals. For example, in the risk based approach, a conservative investor would have a low allocation to equity and high allocation to debt irrespective of goal tenure. However, in the goal based approach, a long term goal would have a far higher allocation to equity vis-à-vis a short term goal. This is because the risk of equity is much lower if held for a longer term besides the potential for higher returns. A lower equity allocation in the risk based approach would also mean that the investor needs to allocate more money to achieve long term goals owing to comparatively lower potential returns from the larger debt portfolio. On the contrary, the goal based approach which has a higher equity component would need a lower cash flow for the same goals (as potential returns would be higher).However, risk profiling an investor is needed for both approaches. One may use the risk profile to choose products within an asset class like say to decide on investing in only large cap funds or both large cap and midcap funds as well as the allocation for each.

Summing Up

There are two methods to construct a portfolio to meet goals. One, is the risk based approach which is based on the investor’s attitude to risk called risk profile. A conservative risk profile would have a marginal allocation to equity in the portfolio while an aggressive risk profile would have a higher allocation to equity. The only drawback of this method is that the asset allocation is the same for the entire portfolio irrespective of the goals. Funds to meet different goals are drawn from a common portfolio.

A more practical approach is the goal based investment approach which constructs a portfolio based on time to goal. A long term goal would have a higher equity component while a short term goal has a lower equity component. One also needs to rebalance portfolios and increase the debt component as the goal nears completion to reduce the mark to market risk. One may use the risk profile here to choose products within an asset class.

Information contained in this article is not a complete representation of every material fact and is for informational purposes only. Regulatory/ taxation details, if any are provided on a best effort basis and are as per the existing laws and subject to change from time to time. The recipient is advised to consult an advisor/ tax consultant prior to arriving at any investment decision.