Goal-based investing: Pick your target and take aim

There is often a significant focus on investments themselves rather than the theories that underpin the construction of a coherent, relevant portfolio that meets an investor's goals.

Most investors are, to some extent, guilty of buying faddy investments that they subsequently regret, or that are too risky or pedestrian to meet their long-term objectives.

In this series, Cherry Reynard guides investors on the basic decisions they will need to take when building a portfolio.

This month we examine goal-based investing. We explain why and how to build a portfolio to achieve specific goals such as raising a deposit for a house.

Investing towards a specific goal, rather than in the vague hope of an investment growing, has a number of distinct advantages. Perhaps most importantly, it is motivating. If an investor can see the tangible result of investing, it is less tempting to divert money towards, say, a special holiday - unless the holiday is a principal goal, of course.

Working towards a goal also imposes discipline. It helps investors focus on exactly what they are trying to achieve: they can pin down their time horizon, whether they need income and the amount of capital they can afford to lose. This will guide investors to growth or defensive investments, bonds or equities, or investments with income or without.

Jonathan Hey, head of user experience at discretionary manager Nutmeg, says: "If people put money away for aspirational goals - getting an MBA or starting a business, for example - they tend to be much clearer about not letting it be nibbled away."

The rationale behind goal-based investing is that it helps investors take the amount of risk they need, but no more. There is no point taking the capital risk of putting an entire portfolio in emerging market funds and private equity if the financial goal is to achieve a return of just 4 or 5% a year. If, however, an investor has lofty ambitions for retirement - a yacht or a Caribbean Island, perhaps - higher-risk strategies may be appropriate.

Building tailored portfolios to achieve individual goals helps investors judge whether they are on track with their investments. Rather than measuring how an investment is performing against a benchmark such as the FTSE 100, they can assess how it is doing against a specific goal.

Patrick Connolly, a certified financial planner at Chase de Vere, points out that financial objectives are far easier to understand and reach if they are quantifiable.

He says: "Having this information allows people to understand how much money they need to invest and what rate of return they need to achieve. Importantly, it also means they can monitor how their investments are performing and whether they are on track to reach their goals. By understanding this, people can then make changes to their investment strategy and contribution levels if they move ahead of their target or fall behind."

A question of time

Short-term financial goals - those expected to take less than five years to achieve - might include raising the funds to buy a car or kitchen, or for a deposit on a house. In general, investors can't afford to take a big risk in the pursuit of such goals, as they don't have enough time to ride out an investment cycle, but they are not as vulnerable to the ravages of inflation. This is likely to mean they are better sticking to saving cash or perhaps venturing into short-term bonds.

With medium-term goals - taking five to nine years to achieve - investors can ride out a market cycle and therefore take some equity risk. But they should retain some bond exposure to balance their portfolios or generate income. The shape of the portfolio will depend on the goal and whether the sum required is fixed.

Many long-term financial goals - raising funds for university fees, retirement or buying a house in the sun - have a time horizon of more than 10 years. Investors tend to take insufficient risk with their long-term investments. Those operating within this timeframe have the luxury of not needing immediate liquidity and being able to ride out a market cycle.

For more on the various time horizons - and funds to consider for each target - read:Investment strategies for short-, medium- and long-term gains.

Income or growth

Financial goals such as raising money for school fees, retirement or retraining may direct investors towards assets that generate income. This might be provided by dividends from developed or (increasingly) emerging market equities in a UK, regional or global equity income fund, by corporate or government bonds, or by property producing rental income. Investors need to decide whether they want a high absolute income or a growing income, which may give them greater inflation protection. They should also ensure they have the right tax wrapper. Income-generating assets placed in an ISA produce valuable tax-free income.

Capital loss tolerance

It is no use building a share portfolio if you are scared stiff of investing in stockmarkets. All investors have an individual tolerance for risk and, while it can be worth stepping out of their comfort zones, they don't want sleepless nights.

Investors also need to consider how much money they have in other investments or savings and whether their goal requires a fixed sum (to pay university fees, for example) or an indeterminate amount (to pay for a holiday, perhaps). To fund the latter, investors may feel able to take more risk.

The first step, naturally, is to define your goals. Then you need to consider how long you have to save up for them, how much you will need to set aside and how fast you will need your investments to grow. Be sure at the outset that your target is achievable. If it requires all your disposable income and a 15% investment growth rate, you may need to adjust your expectations.

Portfolio building

Adrian Lowcock, senior investment adviser at Hargreaves Lansdown, says that before deciding on an appropriate investment strategy investors should look at tax wrappers. Is an ISA or a SIPP the best choice? He says: "Most of the time it is a combination of the two. The exact split will depend on how comfortable you are about tying money up in a pension and how much of your savings you require short-term access to."

He believes longer-term goals may need to be broken down. An investor's thinking might be: I need to get to £x amount by year five. I will take out a stocks and shares ISA each year in full and/or I will contribute £y amount to my pension every year.

Once investors have established whether they are naturally cautious or willing to take some risk, they can begin to determine how much needs to go into shares, bonds, cash, and alternative assets such commodities, hedge funds and property to achieve their financial goals.

He adds: "The critical issue here is to make a note of your portfolio structure, set yourself some tolerance levels and stick to them. This can be done across the major asset classes and also within subsets. So shares can be broken down by region, capitalisation, and growth or income.

The final step is fund selection. Initially, it is better to start off with fewer funds and add to them over time. Pick some core funds covering a number of asset classes.

Tim Cockerill, head of research at Ashcourt Rowan, says the big risk is failing to achieve the growth rate needed. Goal-oriented investors start with "£x and need it to be £y in, say, five years". In deciding how much risk they need to get to that goal, they have to assume a certain growth rate. But this is the biggest area of unpredictability. Cockerill says: "Building in a margin of error makes sense to me, and that means taking more risk. So if you need 8% a year to meet your goal, plan for 10%. The trouble is if markets go against you, the return on a 10% strategy will be less than for an 8% strategy."

Building a portfolio geared to specific goals is difficult, but it gives investors a framework to build and then monitor the success of their investment.