How to Make a Goal-Based Financial Plan

When people talk about investing, the conversation usually starts with products: which ETF, which fund, which shares. Goal-based financial planning starts somewhere else, with a simpler question: what is this money for?

Most people have more than one answer. The same person may be saving for a deposit on a house in five years, for their children’s education in twelve and for retirement in thirty. These are three goals with different time horizons, amounts and levels of importance. Treating them as a single portfolio, with a single level of risk, is a simplification that can turn out to be expensive.

A portfolio for each goal

Goal-based planning organises investing around what the person wants to achieve. Instead of a single portfolio, built for an average return, each goal is treated as a project of its own, defined by three answers:

• the time horizon: when the money will be needed;
• the amount: how much will be needed on that date;
• the priority: what happens if the goal cannot be met.

With these three answers, each goal gets its own strategy. The money for the house, needed in a few years, usually calls for less risk than the money for retirement, which will only be used decades from now.

How people really think about money

This approach comes from behavioural finance, the field that studies how people make financial decisions in practice, and not only how they ought to make them in theory.

In theory, all money is the same: a euro saved for a holiday is worth as much as a euro saved for retirement. In practice, almost nobody thinks that way. We split our money into mental accounts, each with its own purpose, and we react differently to a loss depending on the account it happens in.

We also feel losses more intensely than gains of the same size. This is called loss aversion, and it is one of the reasons why many investors sell at the worst possible moment.

Goal-based planning does not try to correct this way of thinking. It makes use of it. If each part of the money has a clear purpose, it is easier to accept the ups and downs of the part that will only be used twenty years from now, because you know the money you will need soon is somewhere else, invested in a different way.

Risk becomes not reaching the goal

In traditional finance, risk is measured mainly by volatility: how much the value of a portfolio swings around its average. It is the basis of Harry Markowitz’s modern portfolio theory, and it remains a useful measure.

But for someone investing towards a goal, the question that matters is a different one: what is the probability of not having the money when it is needed?

The same swing means very different things depending on the time horizon. A 20% fall in one year is a serious problem for someone who needs the money the following year. For someone who will only need it twenty years from now, it is mostly an episode along the way, as shown in how time changes returns.

This is why a goal-based plan does not promise results. It estimates the probability of each goal being reached with the chosen savings and portfolio. A low probability is not a failure: it is a signal to adjust the time horizon, the target amount or how much you save each month before the problem arrives.

The essentials first

Not every goal is equally important. A common way of organising them is a pyramid of priorities:

• at the base, what is essential: a reserve for the unexpected, everyday expenses, enough income to cover essential spending in retirement;
• in the middle, what is important: the house, the children’s education;
• at the top, what is desirable: a long trip, a holiday home, leaving an inheritance.

The goals at the base call for more safety and less risk. Those at the top can take more risk, because missing them, or reaching them later, does not put the rest at stake.

A new goal enters the plan in the same way. A master’s degree in four years, for example, needs a date, an amount and a place in the pyramid, and a savings plan that does not take money away from the goals below it.

Looking at the whole picture

A goal-based plan also makes you look at your financial situation as a whole, and not only at your investments.

What you already have counts: savings, investments, the house, debts. And so does what you will earn. Human capital, the value of the income from work in the years left until retirement, is often the largest asset of someone at the start of their career.

What could go wrong counts too: living longer than expected, a period without income, an unexpected expense. A good plan does not ignore these risks. It sets out a response to them before they happen, whether an emergency reserve or an insurance policy.

A process, not a result

Investing towards goals is, to a large extent, an exercise in discipline: saving every month, holding the portfolio through difficult times, reviewing the plan when life changes. It is a slow and repetitive process, and that is precisely where its strength lies.

Having the plan in writing helps. A document that states the goals, how much is saved for each one, what risk is accepted and where every number comes from is a point of reference when markets fall and the temptation is to change everything. Like an Investment Policy Statement, it is not there to predict the future. It is there to help you decide calmly when the future arrives.

And because the time remaining until each goal gets shorter, the plan needs a review date. A goal that was ten years away becomes five years away, and the portfolio that suited it may no longer be the same.

How to build your plan on PortfolYou

With a PortfolYou account, Your plan organises goal-based planning into five questions, in this order:

1. Who I am: your risk profile, in the Investor Profile.
2. Where I stand: your wealth, in the Lifetime Balance Sheet.
3. Which portfolio suits me: the split across asset classes, starting with Asset Allocation.
4. How much I need: your goals, in Targets. A house, education, retirement or something else, each with a time horizon and an amount, and how much to save each month for each one.
5. Whether the plan holds: the probability of reaching your goals.

The order is the recommended one, but it is not compulsory. It is a single plan, built with the app’s tools, and what you find out in one question carries over to the next: the risk profile informs the portfolio, your wealth feeds into the goals, and the goals and the portfolio tell you whether the plan holds. At the end, everything sits in a single document, with the source of every number and a review date.

A plan like this does not tell you which investment will do best this year. It tells you something more useful: whether, with what you have and what you can save, the money will be there when you need it.

In a goal-based plan, the question is no longer how much you can earn, but what it takes to get there.

Adapted from “O que é o planeamento financeiro baseado em objetivos?”, originally published on the Future Proof blog.