Unlocking the real sources of value1
Investing is often regarded as a race for returns with an undue emphasis on selecting the right manager. A goals-based savings and investing framework allows us to integrate a number of value-enhancing strategies that are not dependent on the returns race. These would be:
- deriving value from effective allocation to the most tax efficient vehicles over time
- finding the right balance for an individual between their need to take risk, their capacity to take risk, and their appetite for risk
- knowing which annuity best suits the individual and when to buy it
- determining how to effeciently withdraw income when required
- incorporating an individual’s personal liabilities when determining an optimal strategy.
Pulling it all together – from goals to action
When you decide to save, it helps to link those savings to specific parts of your overall well-being. For some people, accumulation may have its own value, but research suggests this is not widespread. Saving may also provide a more intangible benefit such as a feeling of safety or security, or of providing options for the future. In many cases, saving is likely to be linked to a specific objective like buying a car or providing for retirement.
At this stage, it is important to consider your adaptability and your alternative strategies. Your adaptability helps you to identify the bottom of your target range. How much of a miss can you tolerate?
In terms of alternative strategies, this means identifying when either social capital or formal insurance could offer a cheaper alternative. If self-insurance itself is a high priority goal, then it may involve sacrificing other goals. If it’s a medium priority, then other strategies may come into play. In some families and communities, there is a high social obligation to care for parents or the elderly. This social capital may mean that savings alone do not have to provide the full solution for retirement.
You can improve the chances for an individual of achieving financial well-being by thinking these trade-offs and decisions through. We want our money to serve our overall well-being. To do that requires making active choices about what matters and what doesn’t, and translating those choices and priorities into a strategy that makes sense. Hope is not an optimal strategy.
“How much is enough?” is not the right question: Implications for financial services
Offering a robust approach to goals-based savings and investments is not simple for financial services companies to do in the current environment. There is a considerable gap between how we should do this and how things are currently being done.
In many financial services companies, savings and investments are handled separately. There may be one division that looks at financial advice and what this needs to look like to improve savings, and so they might adapt a goals-based language. There may be another division that looks at investment products and they may or may not build them according to a robust goals-based framework. Regardless, even if both divisions are talking the same goals-based language, the problem comes if they do not integrate the advice and investments seamlessly.
Historically, this division has not necessarily been the wrong one. Previous versions of investment theory – such as Markowitz’s risk-return efficient frontier– suggested that these problems did not have to be solved simultaneously. Under Markowitz, there is only one ‘ideal’ risky portfolio and once this is identified, you only have to combine it with a risk-less aspect to generate a whole range of portfolios appropriate for different risk appetites. The questions were separable.
But the mathematics of financial theory has begun moving much more swiftly. By returning to a utility-based framework, we are able to start using methods that solve for the savings and investment decisions simultaneously. Unlike what was thought under Markowitz, this appears to generate much more efficient portfolios in terms of how much you need to save to maximise utility – or well-being – over your lifetime.
A recent paper2 compared how much you have to save using these traditional methodologies – against a newer and more robust framework. What it shows is that using a framework that employs more advanced mathematics means you can achieve the same outcomes with considerably less capital.
