Savings and investments represent the engine room of our financial well-being. Lack of savings can limit the set of decisions for an individual around what can be achieved to further their well-being interests, just as lack of a focused, goals-based investment strategy can well mean there’s a complete mismatch between what a consultant or adviser recommends as a required outcome to meet the individual’s needs, and what gets delivered.
Savings serve two core functions in supporting overall well-being. Savings can protect an individual’s current lifestyle or it can give them options to improve their lifestyle in the future. This improvement is not about having ‘more’ for ’more’s sake’ – it’s about having money available for other things that the individual values.
The new paradigm of goals-based investing is particularly appropriate for linking savings and investments to an individual’s overall well-being. Goals-based saving ties the money you accumulate to a specific purpose. Goals-based investing looks at what strategies you should use to best reach your households’ priorities. The measure of success is how close you come to meeting your objectives and not whether you achieve the highest possible return. This shift in focus has significant consequences for how we build investment products.
Savings and investments represent the engine room of our financial well-being.
When an adviser is helping an individual protect their current lifestyle, there are a few areas which they need to look at. Some of these areas are best addressed with a formal insurance product, for others savings make more sense and there is an overlapping category where an individual could use either.
Emergency savings are a good starting point. These savings cater for those unexpected things life may throw at you. These could include things like losing your job – or leaving your job. But they also need to take into account any deliberate gaps that may have been left in an individual’s health or insurance coverage. It may make sense for an individual to self-insure some risks, or to choose higher excesses or copayments. For all these, some form of savings will need to exist, and it is likely to be in the form of emergency savings as this money could be needed unexpectedly.
Retirement savings are another important point for conversation. But a correct picture of whether retirement savings are adequately requires we maintain a holistic picture of an individual’s savings: pension fund, retirement annuities, preservation funds, post-retirement medical aid, insurance policies and housing, should be included.
Saving can protect a current lifestyle, but it can also open up possibilities for a future lifestyle. These future-oriented savings strategies can be divided as follows: Those that are linked to a particular time-frame such as funding an education programme or going on holiday; those that are independent of a time-frame such as saving for the next generation or funding some wished-for luxury like a new house.
Sometimes future-oriented goals are harder to define. Sometimes one might want to achieve the luxury of options. Savings can preserve a sense of freedom without being directly tied to a specific goal. Savings may help households to feel that a breadwinner could choose to leave their job or take a sabbatical, for instance, without ever intending to do so. This may be linked to a less tangible goal, but it still ties back to well-being.
Setting goals for savings is an intuitive and sensible process. However, knowing how to translate this into an investment strategy is trickier and more technical to get correct.
Most financial services companies will approach goals-based investing as goals-based saving with each goal mapping to a traditional investing product. This is often how many of the calculators available online will approach it. You specify how much you need, how long until you need it, your risk appetite and the calculator tells you how much you should contribute every month and to which traditional investment product.
But this doesn’t explicitly take prioritisation of your goals into account. It expects you to try out various goals, find out what is possible and what is not in the traditional framework and decide which goals to sacrifice. In the traditional framework, most portfolios are built based on a risk-return frontier which assumes that your savings and investing decisions are separable. In a goals-based framework this approach is sub-optimal.
In a proper goals-based investing framework, you would be able to specify your priorities across your full set of goals. Based on this, it would generate an investment strategy – in the form of a asset strategy allocation – which would maximise your probability of reaching as many goals as possible in your order of prioritisation.
So, instead of trying to work out the best way to do things by playing with different combinations, your prioritisation would be embedded in the process to identify the correct investment strategy.
This way of dealing with goals-based investing requires more sophisticated mathematical approaches. For several decades, computing did not allow for a ‘strong goals-based’ approach to be taken. However, our computational ability has now caught up with the problem. In the table, we show some high-level differences between a ‘strong goals-based’ approach to investing and a traditional approach which may only be using the goals-based language.
Understanding the difference in the risk parameter is important. In the traditional model, when we look at risk, it refers to volatility. What this means is that it looks at how you respond to your investment falling 10% in one month, for example, in a 10- year strategy. It focuses on how you feel about the ups and downs along the way, and is mathematically often summarised as a volatility measure.
Risk in goals-based investing is about falling short of your target at the end. If you need a R100 000 deposit for a R1 million house, you could tolerate if the final outcome is R80 000 and you can only buy a R800 000 house. Any lower and it will be harder for you to adapt. A goals-based investing strategy should minimise the probability of any result below R80 000 and maximise the probability of achieving R100 000. The risk isn’t about a bumpy ride; it’s about how far you can afford to fall short at the end.
Ideally, what a goals-based investing framework would also be able to do is navigate the choice between investments and insurance, in cases where both options are available. For instance, you might want to self-insure your car, but doing so means you have to save R1 000 a month, which is a lower priority than saving for your retirement and your children’s education. In this case, achieving all your goals means it makes more sense to use formal insurance for R500 per month than self-insure when you can’t meet your self-insurance goal without compromising higher priority goals.
Risk in goals-based investing isn’t about a bumpy ride, it’s about falling short of your target.
Investing is often regarded as a race for returns with an undue emphasis on selecting the right manager. A goals-based savings and investing framework allows us to integrate a number of value-enhancing strategies that are not dependent on the returns race. These would be:
When you decide to save, it helps to link those savings to specific parts of your overall well-being. For some people, accumulation may have its own value, but research suggests this is not widespread. Saving may also provide a more intangible benefit such as a feeling of safety or security, or of providing options for the future. In many cases, saving is likely to be linked to a specific objective like buying a car or providing for retirement.
At this stage, it is important to consider your adaptability and your alternative strategies. Your adaptability helps you to identify the bottom of your target range. How much of a miss can you tolerate?
In terms of alternative strategies, this means identifying when either social capital or formal insurance could offer a cheaper alternative. If self-insurance itself is a high priority goal, then it may involve sacrificing other goals. If it’s a medium priority, then other strategies may come into play. In some families and communities, there is a high social obligation to care for parents or the elderly. This social capital may mean that savings alone do not have to provide the full solution for retirement.
You can improve the chances for an individual of achieving financial well-being by thinking these trade-offs and decisions through. We want our money to serve our overall well-being. To do that requires making active choices about what matters and what doesn’t, and translating those choices and priorities into a strategy that makes sense. Hope is not an optimal strategy.
Offering a robust approach to goals-based savings and investments is not simple for financial services companies to do in the current environment. There is a considerable gap between how we should do this and how things are currently being done.
In many financial services companies, savings and investments are handled separately. There may be one division that looks at financial advice and what this needs to look like to improve savings, and so they might adapt a goals-based language. There may be another division that looks at investment products and they may or may not build them according to a robust goals-based framework. Regardless, even if both divisions are talking the same goals-based language, the problem comes if they do not integrate the advice and investments seamlessly.
Historically, this division has not necessarily been the wrong one. Previous versions of investment theory – such as Markowitz’s risk-return efficient frontier– suggested that these problems did not have to be solved simultaneously. Under Markowitz, there is only one ‘ideal’ risky portfolio and once this is identified, you only have to combine it with a risk-less aspect to generate a whole range of portfolios appropriate for different risk appetites. The questions were separable.
But the mathematics of financial theory has begun moving much more swiftly. By returning to a utility-based framework, we are able to start using methods that solve for the savings and investment decisions simultaneously. Unlike what was thought under Markowitz, this appears to generate much more efficient portfolios in terms of how much you need to save to maximise utility – or well-being – over your lifetime.
A recent paper2 compared how much you have to save using these traditional methodologies – against a newer and more robust framework. What it shows is that using a framework that employs more advanced mathematics means you can achieve the same outcomes with considerably less capital.
Getting the right answer demands we know the right optimisation framework is to solve the specific problem. This determination is getting more and more complex.
1 Adapted from Blanchett and Kaplan (2013)
2 Dempster, Kloppers, Osmolovskiy, Medova, & Ustinov (2015)