Remember when you were a kid and had a piggybank where you saved money to get that new bike? Perhaps, as you got older, you began saving for a bigger goal, like a new Xbox or PlayStation? Putting a little bit away at a time to finally reach your goal? Well, you may have not known it at the time, but that is the idea behind “goals-based investing.”
Goals-based investment is similar to having a piggybank or using the “envelope system”, another well-known money saving strategy, and the idea is the same – save for your goals, whether a new home, a new car, vacation – or simply set a certain target of investment you wish to achieve. And every time you get paid, you put away a certain amount of cash.
Goals-based investments have gotten a bit more refined over time, but the idea behind the concept remains the same. Rather than putting money into a physical container, goal-based investment uses a “mental account”, where you fund and invest independently in each financial goal. You can set up multiple mental accounts for multiple goals, and then assign to each goal a unique time frame, define how you are going to allocate assets, and then determine what is the risk profile for that goal - how much you are willing to invest in that goal and at what level of risk. For example, the younger you are, the higher the risk you may want to take with your retirement goal.
Rethinking the traditional approach to investment goals
Most 401K (or pension plan) retirement plan investments ask you to determine your time horizon and risk tolerance. For example, you may have taken a short “risk quiz” that asks how you feel about losing 10%, 20% and so forth of your investment. Then, based on how many years you have to save to reach your goal, you will then need to choose from a list of investments that carry different levels of risk.
Another method is to set “target-date” funds, which are designed to match your retirement with the data of the fund; however, this approach does not really help you define how much money you’ll actually need once you retire. Many wealth advisors use a “back of the envelope” approach, which estimates about 70-80 percent of your pre-retirement income as the basis for what you will need after retirement, but this still requires you to have a well-furnished nest egg of about 10 times your final salary.
Most importantly - as many investors who experienced the financial collapse of 2008, the downturn in the Chinese economy, or even last week's US market drop can attest - this approach doesn’t necessarily protect your savings when a sudden downturn throws the market off-kilter.
How does goal-based investment work?
Goals-based investing uses a much more specific approach to goals, so that instead of defining your goal as simply retirement, you define it as retirement at a specific age, for example 59.
Goal-based investment also requires you to rethink risk; while most financial advisors have been practicing goals-based investing for about 15 years, this strategy became critical in the wake of the 2008 financial crisis, and appears to be no less relevant today. According to Jean Brunei, the managing principal of Brunel Associates and author of "Goals-Based Wealth Management: An Integrated Approach to Changing the Structure of Wealth Advisory", most people already have multiple risk profiles that match multiple goals. Brunel, whose company has been practicing goals-based investing since 2004, says this approach makes financial crises like those of 2008 and even the current market fluctuation in China much easier to handle.
Why? Because this type of investment helps the investor measure just how severe a drop in their portfolio is as it relates to their goal; beyond just having money in the future, the investor is able to determine not only whether a drop (and hopefully sometimes an increase) has an impact, but to what degree. This may reduce the investor’s level of anxiety and prevent them from feeling like a ship without a rudder.
Of course, different goals will require you to assign different risk profiles, if your kids are still toddlers, you may have more leeway in assigning risk to their college funding goal; but your emergency fund, at any age, should have as little risk as possible (and, therefore, very little return), helping to reduce your fear that its value might drop.
So how does this apply to equity crowdfunding investments? You may want to determine a goal – a mental account – for your equity crowdfunding investment rather than just stating the purpose of making money, and then assign it a risk factor so that you know to what degree of risk you are willing to invest.