At the Hot Topics session in March 2015, we had a key focus on goalsbased investing and stated that goalsbased investing differs from traditional investing in three critical ways:
- It defines risk as being the risk of an investor falling short of their goal, not as volatility in returns.
- It employs investment strategies and asset classes that increase the probability of meeting those very specific targets as opposed to simply beating an asset mix or peer group benchmark.
- Performance monitoring and measurement is done in reference to whether the fund or member is on target for meeting their funding requirement.
Following on from this discussion, Professor Robert Merton presented at the Hot Topics Summit held in July 2015. He emphasised that our current approach to retirement planning was all wrong, and that we needed to start focusing on securing a monthly income and not net worth.
Our intention for this Hot Topics session is to re-emphasise a few critical points and to demonstrate a practical example of how a goals-based investing approach has been incorporated into a lifestage model.
The article which follows is an extract from our Manager Watch™ Survey of Retirement Fund Managers for 2015.
“The wealth which enslaves the owner isn’t wealth,” according to a Yoruba saying. This principle extends to the investment world – much like wealth, returns are only a means to an end. Some investors mistakenly focus only on their returns, completely ignoring why they invest money in the first place. The vast majority of investors save and invest for a very specific purpose or goal; the investment (and returns earned) are a means to an end. A single parent saves for a tertiary education for her daughter. A graduate starts contributing toward his pension fund to provide an income after retirement. Both investors are interested in whether their savings can pay for these goals, not what return they will earn. Will the single mother’s savings keep pace with the rapidly increasing costs of education? Will markets keep pace with (the large) fluctuations in the cost of buying a retirement income? These investors should not be enslaved by their investment returns, but should rather plan and monitor their strategies relative to their goals. To quote Ainsley To of Credo Capital, “You can’t retire on a good Sharpe Ratio and you can’t eat alpha”.
Goals-based investing (GBI) is an approach to investment strategy design that embraces this advice. GBI has become a popular industry buzzword. GBI advocates designing your investment strategy directly around achieving your goals, targets or objectives. For example, an investor might tweak their investment strategy to have the best chance of earning a stable, sufficiently large pension after retirement. This differs from investors who focus purely on the return they earn on their investments.
Goal-based investing is an approach to setting an investment strategy. Under this approach, the strategy is designed and monitored relative to an investor’s goals (such as a comfortable retirement), not to maximise absolute returns or return-based measures such as a Sharpe Ratio.
Many investors are surprised to learn that maximising returns (or minimising return volatility) is not equivalent to maximising their chance of achieving a goal. Depending on the goal, significant differences can exist between these two objectives and the investment strategy that will best suit each. Think about it like this – the shortest route to your destination might not be the fastest or most reliable route if it is sometimes backed up with traffic. This road might be faster on some days, but there might be a greater chance of a delay on this route. If you are trying to get to an appointment at a specific time, you might not be able to afford risking a traffic delay. You might choose a slightly longer route or a different off-ramp from the highway to avoid this risk (even if your navigation has not figured this out yet!).
Even ignoring this risk, some roads are just consistently ineffi cient and slow, even if they are the shortest by distance. We all have our favourite ‘short cut’ home from work that avoids traffi c by cutting through some less congested, though longer suburban roads.
The same applies when saving for retirement or other goals. Trying to maximise your return is not always the best way to ensure you will get to an acceptable retirement, on time. There are certain risks you cannot afford to retain, because you might not be able to survive on the income that would follow if these risks materialise. It might also be possible to get to an adequate retirement without taking these risks.
Much like the frustrated victim of the traffi c jam who is late for his meeting, you might fi nd yourself working late into your retirement to compensate for these choices. That traffi c jam often happens when you can least afford to be late – like when you are heading to a particularly important meeting or the day you left a little late after you forgot your cell phone at home. The same is true of retirement. Many investors forget that the cost of retirement fl uctuates widely across time. The pension available from annuities might decline at the same time markets decline (eroding accumulated capital), causing the perfect storm.
Practical examples of GBI
The strategy best suited to saving toward a specifi c goal can differ signifi cantly from a strategy suited to earning the highest return at the lowest volatility. This is not an intuitive result, so we will illustrate it with a simple example adapted from the article “Why we all fall down” by Shaun Levitan and Prof. Robert Merton.
Imagine two investors, Thabo and Miranda, are saving for different purposes. Thabo is saving for his retirement while Miranda is saving up the lump sum she needs to pay off her car in the next few months. Both are risk averse and decide to use conservative investment strategies to reach their goals. What is the best investment strategy for each?
Miranda is targeting a specifi c rand value, perhaps R100 000. Thabo has decided he will be investing at least some of his money in an infl ation-linked annuity (a guaranteed monthly income, payable for the rest of his life, increasing with the cost of living). Both investors are risk averse and prefer certainty (this makes the example easier to understand, but these principles extend to move aggressive, risk-tolerant investors as well). Thabo’s fi nancial adviser recommends he invest in a portfolio of infl ation-linked bonds, which will track the cost of his retirement annuity closely, but will deliver volatile returns. Miranda’s fi nancial adviser suggests she invest in money market or cash investments which will offer a more certain rand value at maturity.
The charts below compare the performance of the two strategies. The blue line show the month-to-month performance of the infl ation-linked bond strategy, while the green line illustrates the cash strategy. The fi rst chart shows absolute performance or return; the sort of returns we are used to seeing reported by most managers and in most performance surveys. While Miranda’s strategy offers stable growth with no capital losses, Thabo’s strategy (blue) delivers large losses in some months and volatile returns across other months. Thabo’s strategy looks like a far more risky approach, but is it really?
