Objective Based Investing

Last month we discussed sequencing risk; that is, the risk of receiving the worst returns in their worst order.  As promised, this month and in the following month, we will discuss strategies used to mitigate sequencing risk.  This Wealth Pipeline specifically discusses objective based investing.

Objective Based Investing

Objective based investing is a method of asset allocating that targets a certain investment return rather than the highest possible return for a given level of ‘risk’.  Essentially, this investing approach entails an investor clearly articulating their specific personal goals and then constructing their portfolio in a manner most likely to achieve those goals.  An investor’s specific goals may be to generate 70% of their existing income once they retire or have enough capital to finance a European holiday in three years’ time.

The Traditional Approach (Risk Profiling and Strategic Asset Allocation)

The traditional approach of asset allocation is determinant on an investor’s risk profile.  This is usually accomplished through a questionnaire.  The questionnaire aims to determine the investor’s knowledge of markets and more specifically, their tolerance to volatility of investment returns.  The investor’s portfolio is then constructed by selecting and weighting investments that correspond with the investor’s tolerance for risk.  The main problem with this approach is that it does not consider the idiosyncratic goals of the investor. 

Strategic Asset Allocation v Objective Based Investing

Take an investor who has $2,000,000 in superannuation and would like to generate $80,000 per year (in today’s dollars) for retirement.  This investor also has a large appetite for risk.  That is, they are happy to accept the possibility that in any year their investments could generate either a 20% positive or negative return.  Using strategic asset allocation, this investor’s portfolio would consist of mainly assets likely to produce the greatest return.  Under objective based investing, the investor’s goals (rather than the investor’s risk appetite) would be the main determinant of asset allocation.  Therefore, with objective based investing, this investor’s portfolio would be made up of investments with the aim of delivering returns of 4% ($2,000,000 x 4% = $80,000). 

The example above is very simple due to the healthy capital base ($2,000,000) relative to the income goal of the investor ($80,000 p.a.).  However, more often than not, an investor’s capital does not permit them to reach all of their financial goals through more conservative investments (such as term deposits).

The Four Buckets

Generally speaking, with objective based investing, there are four categories or ‘buckets’ of capital employed by an investor.  The table below outlines each of the four buckets and the specific purpose it is used for within an investor’s portfolio.  

Source: Profile Financial Service, February 2013.

Tips for Financial Goal-setting

The investor clearly defining their financial goals is the cornerstone of objective based investing.  Further, the basic challenge to effectively execute the approach is having the requisite capital to attain those defined financial goals.  Investors will have many goals, and it is likely that some or even many of them will conflict.  Therefore, when defining financial goals, investors should not be reluctant in outlining all possibilities.  Second, these goals should then be classified into the following categories: ‘have to now’, ‘have to later’, ‘want to now’ and ‘want to later’.  Generally speaking, when goal-setting is approached in this manner, initial goal conflicts become easier to rationally prioritise.

Concluding Comments

As has often been the case with the subjects discussed in our Wealth Pipelines, there are no hard and fast rules when it comes to implementing investment strategies and objective based investing is no exception.  Nonetheless, once financial goals have been articulated and assessed (a process which may take multiple efforts), the proportion of capital to be dedicated to each bucket becomes more obvious.