Many investors today manage their investments based on traditional asset allocation strategies, or class optimization. This method asks the question: How can different asset classes be combined to make the return-to-risk relationship as favorable as possible?
Although this sounds like a good rationale, what this approach might fail to address adequately are the unique financial goals of an individual or family. That’s where goals-based asset allocation comes in.
Goals-based asset allocation takes into account three factors: 1) your risk tolerance 2) your minimum acceptable return rate, and 3) your definition of success.
It’s an investment strategy tailored to your specific financial needs and your investment goals.
Yet, in order for your financial advisor to be able to provide you with a goals-based asset allocation strategy, you need to think about your goals. Are they to send your kids to college, buy a vacation home, plan for retirement or make a philanthropic contribution? Each goal will have a different time horizon and a different asset allocation.
To illustrate how goals-based asset allocation works, let’s review paying college tuition as an example.
Your daughter has just started her freshman year in high school, reminding you that her college bills will start in just four years. You have been saving and investing in a 529 plan and now have $160,000.
In speaking with your financial advisor, you have determined you’ll need about $200,000 in four years to cover her total college costs, you don’t want to lose a lot of money, and you don’t have much time to recoup losses. You also know that any shortfall at this point can be addressed through student loans.
In taking a goals-based approach to developing your investment strategy, a disconnect becomes obvious between the risk you are taking and the risk you need to take.
Given your need, timeframe and current portfolio value, you require an annual rate of return of about 5.75 percent. You also noted that your minimum acceptable return is 0 percent, or no loss of principal.
If you experience downside risk in the next four years, there is not enough time to recover the losses before your daughter starts college. The risk of a portfolio designed with the potential return goal of 5.75 percent is significantly lower than the current risk in your portfolio, and has an average expected return in line with the $200,000 goal.
Because of the lower level of risk of this portfolio, there is less of a chance of falling below your minimum acceptable return.
How can you make goals-based asset allocation work for you? Here are three steps you can take:
Develop a plan. Articulate your goals and assign an appropriate time frame to each one. If you have only one or two goals, you probably need to be more thorough.
Create an investment policy statement. Work with your financial professional to create an investment policy statement that will serve as a complete road map for your wealth plan.
Measure success over time. Determine appropriate benchmarks based on your goals (not necessarily based on industry standards like the S&P 500), and measure your portfolio’s performance against this customized benchmark.
Remember that every investment portfolio has some level of uncertainty. Also, capital markets don’t always behave as expected.
Goals-based asset allocation is a more personal approach to investment strategy designed to help you meet your personal financial goals. Whether you are saving for retirement, aiming to buy that vacation home on the beach, planning to give to charity or planning for all of this, I hope you find it works for you.
Gordon Brazington is a financial consultant with Wells Fargo’s Wealth Management Group in Vancouver. He works extensively with high net worth individuals who have a variety of complex financial issues. He can be reached at 360-993-3763. Financial Consultants are registered representatives of Wells Fargo Investments LLC (member SIPC), a non-bank affiliate of Wells Fargo & Co.
