Financial Planning: Goal Planning and Asset Allocation

You cannot leave your financial health to chance. A financially secure life requires you to create a strategically optimised financial plan that aligns with your goals. Identifying your investment goal to create a sound financial plan helps you to reach your objective faster and in a more disciplined manner. Several studies have found how using a goal-based financial framework leads to an increase in wealth over time. A financial advisor can assist you with prioritizing your goals and allocating your assets smartly to help in the success of your goal-centric financial planning.

When you begin the process of creating a financial plan, you keep your goals in mind. Then you work backwards and create an in-depth plan to achieve the set targets. Goal-based planning requires you to allocate your assets across different investments to achieve a specific life goal. This practice will ensure that you get the right amount of funds at the right time. However, for this to be successful, you need to precisely allocate your assets as per your risk tolerance and investment horizon.

Here is what you should know about goal-based asset allocation:

What is asset allocation?

Asset allocation stabilities your risk and reward by allotting your assets as per your financial goals, risk appetite, and investment period. The strategy involves investing your money across asset classes in varying proportions. Typically, there are three primary asset classes – equities, bonds, and cash equivalents. However, investment portfolios can also comprise alternative assets, such as real estate, commodities, art, derivatives, etc. Each asset class has a different level of risk and return and is categorized by its behaviour over time.

The main objective of asset allocation is to reduce the concentration of risk in your portfolio while allowing you to earn considerably balanced returns. Asset allocation works on the principle that asset classes have no perfect correlation. Hence, when one asset class reduces in value, the other asset class can cover for it. In the short term, asset allocation provides much-needed diversification to your portfolio. In the long-term, asset allocation enables you to accumulate wealth and achieve your financial goals easily.

Why is asset allocation important?

Asset allocation is a principal determinant of your investment results. Moreover, asset allocation also determines your risk level. As an investor, you can use different asset allocation strategies for your goals. For instance, if you wish to save for a new car, you might prefer allocating your funds in short-term bonds and certificates of deposits (CDs). However, if you are creating a retirement portfolio, it may be advisable to create a more return-based portfolio. You could opt for retirement accounts like an IRA (Individual Retirement Account) or invest heavily in stocks (if you are more than ten years away from retirement). Since you will have a lot of time before retirement, your portfolio will be able to ride out the short-term fluctuations. That said, if you are near retirement, ideally, your asset allocation should be more conservative and focused on capital preservation rather than high returns.

What are the different types of asset classes?

Most commonly, there are three classes, each with a different level of risk and return.

• Cash: Cash or cash equivalents, such as certificates of deposit (CD), money market funds, etc., are the least risky assets for your portfolio. However, these assets also offer no returns. Instead, the return on such assets is considered negative when mapped with the cost of inflation.
• Bonds: Bonds or fixed-income investments are safe assets that offer a guaranteed return and low risk, unlike shares. When you buy a bond, you are lending money to a corporation or the government, or the Bonds are usually issued by companies, municipalities, states, or the central government. In return for the money borrowed by the bond issuer, you get a fixed return for a specified duration. However, now variable, and floating interest rate bonds that offer returns as per the market, have also become quite common. The safest type of bond is the U.S. Treasury bond. These bonds are 100% backed by the federal government but only offer a marginally higher return than cash. Alternatively, municipal bonds offer a higher return but are riskier than Treasury bonds. Bonds tend to provide the optimum level of diversification to your portfolio as per your risk tolerance and investment horizon. For instance, if you are near retirement, you would want to invest more in bonds to get assured returns with less risk. However, too much investment in bonds is also not an ideal asset allocation since their returns might not be able to offset the impact of inflation in the long run.
• Stocks: Stocks or equities are the riskiest type of assets but also offer the highest returns. Over time, the return on stocks has the potential to outpace inflation, enabling you to achieve your financial goals. Stocks can further be spread into small-, mid-, and large-cap companies for optimal diversification. Ideally, you can have a higher asset allocation in equities during the younger years of your life. This is because you have a longer investment horizon and your ability to absorb market volatility is much higher. A sound portfolio is a thoughtful combination of stocks and bonds that can offer attractive returns and risk as per your tolerance level.

In addition to these asset classes, there are other alternative investments you can choose to fit your goal. These include:

• Real estate and real estate funds
• Derivatives
• Commodities such as gold, oil, etc.
• Currencies

How does asset allocation work?

Asset allocation can be best understood with the help of an example. For instance, you have $10,000 for investment. You decide to split your funds into three different asset classes – equity, bonds, and cash. You are a risk-taker and more than 10 years away from retirement, so you decide to place 60% of your money in stocks. You further split this into large-cap and small-cap companies for optimum diversification. You buy index funds worth $4,000 of large-cap companies and $2,000 worth of index funds of small-cap companies. Further, you place 35% of your funds in bonds and other fixed-income investments, such as Treasury Bills and municipality bonds. In all, you secure $500 in cash and cash equivalents.

Now, in this case, if the market witnesses an upswing, you will be benefitting from your equity shareholdings. However, if the market faces a downturn, you will be cushioned through bonds and other secure investments that are not as volatile as stocks. This means that when you place your assets in different baskets, you have a better chance of getting higher returns, and you can also optimally diversify your portfolio to reduce risk and achieve your financial goals.

How is asset allocation related to your goals?

Your goals heavily influence your asset allocation. So, whether you aspire to create a retirement corpus, own a home, buy a car or a yacht, pay for your child’s education or marriage, you will need to factor in your objective when determining the distribution of your funds across different assets. Your goals, investment horizon, and risk tolerance are the three primary factors that impact your asset allocation.

Investment goals such as buying a house, sponsoring the education or marriage of a child, retirement planning, etc., have to be mapped with your asset allocation. Further, the period of investment and your risk tolerance has a considerable impact on your asset allocation. For instance, if you are 58 years old and nearing your retirement in another few years, your investment horizon is small, and your risk tolerance is not very high. Hence, the ideal asset allocation would be to buy more bonds and create a conservative portfolio with an aim for capital preservation rather than growth.

Alternatively, if you are a young investor in your early 30s and wish to save and invest to buy a house, it could help to opt for a more aggressive asset allocation. You can easily put 60% or more of your funds in equity and balance the rest with bonds and cash equivalents or alternative assets like commodities or real estate. As per experts, you can also follow the rule of 100 to determine the percentage of stocks you should hold. You can divide your present age by 100 and the answer would be the share of your funds that ideally should be invested in stocks.

That said, for any financial goals that require money in a year, the asset allocation should primarily be cash because if invested, a significant portion of your principal might be lost before you need it. However, for money that you might need in two years or a short time, consider placing it in income-producing assets such as CDs, Treasury Bills, and bonds.

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What is the perfect asset allocation for your goals?

As per experts, there is no perfect or standard asset allocation. Asset allocation is a personal choice dependent on many factors, including your age, risk tolerance, and financial goals. Moreover, your situation or life stage, such as being single, married, married with kids, etc., also significantly influences your asset distribution. Therefore, your investment policy and portfolio asset spread will be unique and based on your present needs and future expectations. Further, your ability to stay the course during adverse market situations also impacts your portfolio asset structure. With time, as your needs change, your asset allocation will also require correction and adjustment. Gradual monitoring and change adaptation is a critical part of the process.

Choose target-date funds to manage asset allocation

Choosing the right asset allocation is extremely crucial for a portfolio’s success and, consequently, for the fulfilment of your financial targets. However, an alternative to asset allocation for goal-based investment is target-date funds. A target-date fund is a mutual fund that is invested across multiple asset classes and gradually shifts towards a more conservative asset allocation as the target date approaches. Target date funds manage your asset allocation and you do not have to continually monitor or rebalance your portfolio to make the asset adjustments.

For example, assume that you invest in a target-date fund, which will mature in the year you retire (assuming 2055). This fund will presently invest most of your money in high-risk assets, such as stocks and the remaining in bonds. However, as you approach 2045 or further, the asset allocation will become more conservative to include more bonds and fewer equities.

As a general practice, target-date funds follow best investment practices. These funds are optimally diversified across different asset classes as per your age and financial goal. These funds are also easier to manage as you are not required to actively participate in the management. However, despite being a preferred medium of goal-based investment, target-date funds do not take into consideration your risk tolerance or even the possibility of changing life situations. For example, you get a big promotion or a big inheritance and you decide to retire seven years earlier than planned. In this case, you should preferably change your asset allocation and make it more conservative if you are nearing retirement. But in the case of target-date funds, your asset allocation might be different as it denotes the year in which you primarily planned to retire.

To sum it up

Overall, as an investor, it is important to create a comprehensive and foolproof financial plan that considers your goals and accordingly distributes your assets, enabling you to meet your set targets in time. However, there is no particular approach that can address asset allocation. Your asset allocation is unique, personal, and dynamic. It changes as you advance through the different stages in your life. It is also particularly stimulated with the vagaries in your financial situation and your objectives. Asset allocation is not a one-time event. It requires disciplined progression and fine-tuning over the duration of time.

A well-balanced asset portfolio based on your goals is ideal for maximizing returns and minimizing investment risks. If you need expert consultation to create a perfect mix of assets as per your goals and risk tolerance, consider engaging with a professional financial advisor.