Most investors focus on traditional benchmarks, such as the Standard & Poor’s 500 index, to evaluate the success of their investment portfolio. Unless you’re only invested in large-capitalization, predominantly U.S. equities, the S&P 500 may not be an apt comparison to your portfolio.
Further, how one did relative to a market index doesn’t really mean anything — what the investor really wants to know is if they’re on track to meet their goals, like paying for college or taking an early retirement. Goals-based investing helps to solve that problem by looking at investment performance in relation to progress on personal goals; not just market returns.
Asset allocation and risk tolerance. To help mitigate investment risk and manage volatile markets, it is wise to create a diversified portfolio of assets. A diversified portfolio typically contains a variety of assets; such as large- and small-cap U.S. equities, international equities, fixed income investments, as well as sector and specialty funds. The investor’s expected return for the entire portfolio can be projected using a weighted average of historical returns for each asset class.
The actual or expected return of such a diversified portfolio based on your personal risk tolerance doesn’t translate well to the market returns of an index containing one asset type, like the S&P 500. So when investors try and compare the two, it can cause some to begin trading away investment gains in search of higher returns.
If you find yourself upset that your portfolio didn’t perform as well as the market, just remember the reason for holding a diversified portfolio: to mitigate risk and reduce the variability of returns. In some years, your portfolio may not experience the same highs as the rest of your index of choice but it probably won’t get hit by the same lows either.
Goals-based investing. A goals-based investing strategy emphasizes the investor’s personal goals, and tracks progress towards achieving those goals when reviewing performance. For example, a couple may wish to purchase a vacation home in five years, send their child to college in 15 years and retire in 25 years. Some financial advisors may actually create separate accounts for each goal. During the annual performance review, the advisor would discuss with the couple that their return was, for example, 5 percent overall and they’re still on track to achieve their stated goals. What if the S&P 500 returned 8 percent that year? Or 3 percent? It shouldn’t weigh too heavily on the couple as they are projected to meet their goals without taking on any unnecessary risk.
Goals-based investing is sometimes criticized as a way for financial advisors to hide behind poor-performing portfolios or sell investment products to fit their own needs. While the sad truth is that these types of situations do occur, one could argue that in those instances the real problem is with the relationship itself. Transparency and trust are key components to any advisor-client relationship. Choosing a fee-only advisor helps address many of these concerns, as fee-only advisors do not receive any commissions or other compensation for investment recommendations and they do not sell any financial products.
Using a goals-based approach to saving. If you’re just starting out and not ready to invest in the market yet, a goals-based approach can also help you save. Consider setting up different savings accounts with your bank — you can even name them with your goals. Each month, set up automatic transfers from your checking account (or wherever your excess cash is held) to fund your various goal accounts.
Maintaining separate accounts can help savers feel more confident with their financials. Even if the picture isn’t as rosy as you’d like, goals-based accounts adds transparency to your situation. If you’re unhappy with the timeline to achieve short-term goals with your current rate of saving, a goals-based approach makes it easier to evaluate your options. Perhaps you can spend less to save more or instead choose to reprioritize your goals.
Also keep in mind that if you took any withdrawals during the year, your individual performance metrics will likely reflect that and it will hurt your overall return. The returns of a broad market index will not include any type of timing-related return, including when you purchased or sold securities, further distancing how related the two metrics may be. Even without adopting a true goals-based investment strategy, shifting the focus away from market-based goals and towards achieving your actual goals can make data from a year-end performance review something you can actually use.
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Reshape the Way You Measure Your Portfolio’s Success originally appeared on usnews.com
