Why do we invest? The simple and obvious answer is to make lots of money. But let’s think this through a little more - after all, you are giving up spending today in order to save and invest for tomorrow.
There must be some reason - a future purpose or goal for this sacrifice. Its importance (or present value in economics terms) must outweigh the satisfaction of today’s spending. Your investments represent hard-earned money that you have set aside for a future goal, whether it is to buy a home, pay for your child’s college education, or an income in retirement. These are the reasons we save, so we need to have a proper investment strategy that focuses on how to reach these goals.
This is known as goal-based investing and it matters.
When you invest with a defined purpose of achieving a certain goal, you can better identify the right strategy, how much you need to invest and the appropriate level of risk to take to get you there.
We often compare our investment success against short-term market returns or our friend’s portfolio performance. It’s great if your portfolio beats the S&P 500 Index and your friend this quarter - but what does that really mean for you? Investors sometimes equate the volatility of their portfolios as risk, or perhaps even more complex indicators such as Value at Risk. But your real “risk” is not about underperforming the benchmark. It is the risk that you do not reach your intended financial goal. It is being unable to afford the home you want or retire with the lifestyle you desire.
Periods of drawdowns are emotionally tough for any investor to handle. But when you focus on long-term goals, it is allows us to be less distracted by short-term market volatility and noise. You will be less inclined to act irrationally when markets are not performing the way you expect and succumb to your emotions. You will refrain from selling down your positions or changing your investment strategy to a less risky portfolio that will reduce your chances of reaching your goal, instead focusing on staying true to your investment plan. Losing money this month, quarter or year isn’t as scary when you know that you don’t need that money for another 5, 10 or 20 years, and you are still on track to reach your goal.
Once you decide on the “why”, you can decide on the “how” and use your goals to drive your investment strategy and monitor progress. Properly simulating or calculating the chances of reaching your goals, and taking appropriate action to get to you achieve those goals is a critically important part of that process. This will lead to better strategy on how much to save and when, where to place your money and in what type of portfolio, and how much risk you should take and when.
Imagine you have worked and saved diligently for 35 years and you are set to retire, but your poor investment decisions of the past have led to a significant shortfall in funding your pension. You either have to work beyond your retirement age or make drastic lifestyle changes to reduce spending. Regardless of short-term volatility in markets, good planning should still help you get to your goals. By building appropriate portfolios and taking into consideration when we actually need the money or how we want to spend the money in the future, we can take and manage an appropriate amount of risk in the process to improve our chances of success.