The Incomparable Virtues of Goals Based Planning

By Steven Smith | Financial Lifestyle

Dec 21

One of my standard cocktail party questions when conversing with investors is: How much are you trying to earn with your investments? A typical response is: As much as I can. Then I follow up with: Well, how will you know when you’ve done that? – I often get a blank stare.

These are of course trick questions designed to stimulate a conversation. (Inevitably, some of my subjects just go directly to the bar for another beer.) But there is a profound matter here worthy of further discussion: What should be the goals of an investment strategy and what is the process for developing them?

Doing the Roomba

Investing does not occur in a vacuum. One method might be to take your risk tolerance temperature, and throw a portfolio together that vaguely matches it.  Then see how you do and have the results determine your ability to spend. That seems backwards.

A better method is to undertake your own personal version of Simon Sinek’s, Start with Why. Then your portfolio becomes integrated with your life; not standing apart. It also helps you keep your eye on the ball, allowing the inevitable short-term portfolio losses to be kept in context.

Needs, Wants & Wishes

Generally we break down retirement planning into the two financial halves of your life. The first, is clinically called the “accumulation” phase. Prior to retirement the focus is on how much you can save toward funding your long term goals.

Planning for the second, so–called “decumulation” phase, is far more robust. During retirement, lifestyle goals are broken down into four main categories: 1) essential spending 2) discretionary spending 3) maintaining an emergency fund and 4) legacy goals. It’s critical to prioritize them and to determine how much you will need or want to spend on each of them. And remember, goals are not just “expenses.” They represent the hopes and dreams for you and your family and your community. Defining goals shouldn’t be like going to the dentist. But rather an engaging conversation with yourself and your family.

Tools in the Toolbox

There are myriad risks to those goals and a variety of tools to manage them. The most significant risks are longevity risk (the possibility that you will outlive your actuarial life expectancy); inflation risk (the loss of purchasing power of a dollar over time); and sequence of return risk (the notion that portfolio losses early in retirement are harder to recover from.)

Good planning looks at all the assets on the household balance sheet – including human capital, financial assets, insurance, Social Security and Medicare.

So a  good first step is to determine a way to have as many of your “essentials” as possible be funded by “safe” or “guaranteed” sources such as Social Security, pensions, bonds or annuities.

Believe it or not, some people can achieve all their retirement spending goals without taking any market risk. Think Suze Orman, whose resources are large compared to her spending. That’s why she can proclaim: “I have all my money in municipal bonds.” Others shouldn’t have exposure to the markets. Either because, even with good professional coaching, they just don’t have the temperament to withstand the volatility. Or, they face substantial odds of running out of money unless they buy a lifetime annuity.

For most of us, we will be somewhere in between; engaged in a tug of war between how much of your money you want to spend and how much you can spend. We typically address the dilemma by funding as many of our essential needs as possible with relatively less volatile resources and then constructing an efficient investment portfolio to partially manage inflation and fund our aspirational and legacy goals. Many financial planning professionals now call this the “floor and upside” strategy.

How Far Over Your Skis?

Being a frequent and reasonably competent skier, I feel comfortable applying this well-worn metaphor to the subject of investment planning. The expert skier picks her way through the moguls on a black diamond run, moving her center of gravity out and over the top of her skis and down the fall line applying just the right amount of edge pressure to complete the turn.  The more investment risk we want (or need) to take to achieve our goals, the more skill and confidence we have to apply. In the case of investment skill it’s choosing the asset classes to include in a portfolio and having the confidence and fortitude to stick with the plan; thereby avoiding the proverbial yard sale to fund our retirement.

Applied Science

Fortunately for investors, researchers and software developers have been working for decades to provide us with the background and some fairly sophisticated and inexpensive methods to assist us in this endeavor.

We have sustainable withdrawal rate studies; resulting in the so-called 4% rule – concluding that except under the most dire market conditions, investors can withdraw an inflation-adjusted 4% from a moderately aggressive portfolio. Of course, the 4% rule is not a rule at all, but just a baseline starting point. Further studies have developed dynamic spending variations that may allow for more lifetime spending. Others conclude 4% is too much.

And we now have powerful off-the-shelf software tools – including Monte Carlo analysis and other forms of stress testing to build models and asses “what if” scenarios, side-by-side.  The output from all this analysis is your “required rate of return” – an actual portfolio target of 6% or 7% or whatever may be necessary, depending on your personal goals and how much risk you have decided to take. Then you build a portfolio to match. The results of this planning should also be understandable to regular people and never in the form of an absolute Pass/Fail. Instead, it’s best considered in the form of a route map or GPS coordinates allowing for mid-course corrections as necessary to get you to your destination.

Confident Humility

Perhaps the most important arrow in the quiver is humility. Realize that any such planning is a process – applying tools to manage uncertainty – which will never entirely disappear. We make assumptions, but we don’t make too many. And we focus on the most important ones. More data doesn’t mean a better plan. A plan is a range of possibilities and needs to be updated. As the economist John Maynard Keynes famously said, it’s better to be vaguely right than precisely wrong.