Why do you invest?

The difference between goals-based investing and chasing returns.

What are your reasons for investing? Do you invest because you want to achieve the best possible performance and outdo your neighbour or colleague? Or do you invest to achieve certain goals?

These goals could include a retirement income, tertiary education for your children or buying a new car.

Dwayne Kloppers, investment actuary at Alexander Forbes, says goals-based investing is about designing an investment strategy around a goal.

It is not the same as a strategy that merely aims to maximise returns or risk-adjusted returns, but rather an approach that recognises that you have certain investment goals you want to achieve, he says.

It is similar to an insurance company that has particular obligations it has to meet in the form of annuity payments.

“It [goals-based investing] is designing an investment strategy to meet those objectives.”

Kloppers says one of the first responses to this argument is often whether this is not the same thing as getting the best return. Investors may argue that getting the best return will automatically allow them to achieve their objectives.

But there is quite a big difference, he says.

“Strategies that are designed for a specific goal don’t look the same as strategies that are just designed to minimise volatility or maximise expected return,” he says.

How it works

The difference in approach is illustrated in the charts below. The first chart depicts the performance of cash (in grey) and inflation-linked bonds (in turquoise).

Kloppers says in terms of outright performance inflation-linked bonds are very volatile. This is because bonds have a long duration and every time interest rates move, their price fluctuates quite a lot.

Looking at the chart in isolation may lead investors to conclude that inflation-linked bonds are quite risky assets as they move around considerably compared to cash.

The movement of these two asset classes is also displayed in the chart below, but this time is relative to the price of an annuity. In this instance, cash (the grey line) is more volatile.

Kloppers says inflation-linked bonds behave more like an annuity. Although its absolute month-to-month performance can be quite volatile, for someone who is interested in buying an annuity, it is a much lower risk asset than cash. Similarly, in absolute terms, cash is a very stable asset, but relative to the cost of an annuity it fluctuates considerably because the annuity price is moving around.

Practical application

Consider two fairly risk-averse investors, who both want to buy something in a few months’ time.

Kloppers says if someone wants to send her daughter to university and needs R30 000 in December to pay for it, the cash investment could work, but the volatility of inflation-linked bonds would make it inappropriate.

Conversely, a cash investment won’t be that useful for someone who is saving for retirement because the amount he would be able to buy for his retirement would vary considerably due to the fluctuation of the annuity price relative to cash. In the example, the inflation-linked bond removes some of that risk.

“Your goal actually impacts what you should be investing in. In this case, it shows what is the low risk asset,” Kloppers says.

However, goals-based investing does not necessarily involve low risk strategies and is not the same as “derisking”.

Many people would need to take on risk. A 20-year old saving for retirement is never going to achieve that goal by only investing in cash or inflation-linked bonds throughout his working life, he says.

“He is going to have to take on equity risk to get a higher return to get him there.”

Goals-based investing involves taking on risk relative to your investment goal or liability. These strategies are designed with a goal in mind, not specifically to beat another manager, Kloppers says.