It’s all well and good to think about goals when you have a million dollars in the super account, but what about people who want to achieve financial goals in circumstances where they have limited current capital. How can a goals-based approach serve them?
There are many people in this position and there are some useful goals-based investment strategies customers can use. It is extremely important to be aware though, that these strategies will exhibit high levels of short-term price volatility and are only suitable in some specific situations.
The goals-based approach
In the goals-based approach to financial advice, a client specifies the timing and future dollar amount of their spending goals and articulates the level of importance attached to each goal. Their adviser then works out how much of their current capital (and future savings) to allocate to specific investment strategies to achieve as many of their important goals as possible.
Goals with high priority (eg: to meet essential living needs in retirement) and goals with a shorter time before consumption commences naturally receive the most attention. The capacity to take investment risk to achieve these goals is limited due to their importance. For many clients, these goals require the allocation of a large proportion of their current capital and future savings.
So, it may appear that goals-based investment is constrained in its risk-taking capacity and that the level of its potential returns is capped. That isn’t the case. The attributes of an investment strategy are determined by the characteristics of the goal.
Capacity for return-seeking strategies
In fact, I would argue that a goals-based framework supports a more sustainable exposure to strategies with high prospective return by separating this money from the capital invested to support higher priority goals.
From a behavioural perspective, when a client knows that a separate risk-focussed portfolio is funding their higher priority goals, it’s easier for them to maintain confidence in their return-seeking portfolio during inevitable bout of volatility.
I believe long-horizon goals are best funded by the commitment of a relatively small amount of initial capital invested in a portfolio with a high prospective return. This is true even where the goal is considered high priority. In this case, as time progresses, the adviser will suggest a shift of the (now larger amount of) capital into a more risk-focussed portfolio.
For many goals there is often a base cash flow requirement as well as an aspirational amount. A family saving for a holiday home might fund the future cost of an entry-level house with a targeted allocation of capital to a risk-focussed portfolio strategy. They can allocate any residual capital to a return-seeking portfolio which, in favourable market conditions, might enable a purchase on the waterfront.
Investing to achieve goals with limited capital
The goals-based framework places portfolio managers in an advantaged position because they are better placed to understand their clients’ preferences for the capital they have allocated.
Portfolio managers of patient capital seeking high prospective returns can pursue long-term opportunities without reference to peers, benchmarks, or constraints on short-term volatility.
- Here are some of ingredients useful to patient investors seeking high returns over the long term:
Invest in assets and strategies which provide diversified exposure to a range of risk premia, including the premium for illiquidity. Equity premia are likely to be the largest contributors to overall portfolio risk and return.
- Within the equity market, patient capital can take advantage of the well-documented tendency of the shares of companies with high levels of profitability, and those with low share price relative to their corporate fundamentals, to deliver above average investment returns.
- There is a preference for approaches to active management that focus on information that explains longer horizon price performance. Such portfolios are likely to be concentrated in a small number of securities and exhibit low turnover. Deep value and long-term growth strategies as well as thematic approaches can exhibit these characteristics.
- There is scope to have a meaningful commitment to strategies that exhibit uncomfortably high short-term volatility. For example, small and medium sized companies in emerging markets are very volatile but can be priced to deliver high returns over the longer term.
- Assets whose cashflows tend to adjust with inflation can provide good medium-term diversification in the event of an inflation shock.
- Remain fully invested in growth assets unless forecast prospective returns are well below normal.
Investing to achieve goals with even less capital
If capital is particularly scarce, it may be necessary to introduce some leverage to improve the likelihood of goal attainment. Of course, considerable caution is required. While leverage can boost expected returns, it will certainly magnify volatility. When you adopt a levered strategy, there are some scenarios where the shortfall relative to the goal is uncomfortably large.
A couple of my colleagues have been investigating how much leverage is appropriate and the best underlying strategy to which to apply leverage if you want a solid chance of attaining a goal when initial capital is scarce. Of course this won’t always be the case but to summarise their conclusions:
- Moderate levels of leverage can improve the expected growth rate of invested capital.
- A high cost of debt produces a drag on portfolio returns.
- The cost of debt rises with increasingly leverage and with the complexity of the unlevered portfolio.
- Portfolio volatility produces a drag on the expected compound growth rate on investment. Its impact on return is proportional to the square of the volatility which itself rises with leverage.
- Too much leverage leads to a reduction in return prospects and the potential for goal attainment.
- A leverage ratio of 1.8 (ie: 1.8 dollars of exposure for each dollar invested) applied to an Australian equity portfolio with moderate alpha expectations can deliver a strategy with a strong rate of prospective growth.
- It is important to be aware of potential spikes in the volatility of the unlevered portfolio. It may be appropriate to temporarily reduce leverage in high volatility regimes.
Goals-based investment strategies aren’t all focussed on dampening short-term volatility. Some goals are best funded through long-horizon strategies with a high prospective return. In some situations, the thoughtful use of leverage can improve prospects of goal attainment. These strategies can exhibit heightened short-term volatility. So it’s particularly important to support clients who allocate capital to these strategies throughout their investment journey.
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