I’m a big fan of the goal-based (or ‘liability driven’) approach to investing. A ‘goal’ really just means “something I think I might need to spend money on in the future”.
From a planning perspective, it has a number of impressive strengths. It encourages you to think about the future, which helps you identify things you might have to spend money on, and think about how much they might cost. If you identify and start saving toward future expenditures earlier, you’ll actually need to save less. With more time, returns do more of the work for you.
For example, imagine you want to save up $10,000 with an investment that earns 4% interest above inflation. The table below shows how much you’d need to save, broken down by how many years ahead you start saving. If you can identify a goal 1 year in advance, you can save $180 less. By 5 years out, you’re saving a total of about $1,000 less to reach the same $10,000.
|Years saving||Monthly Saving Required||Total Saving Required||Total less than $10k ($)||Total less than $10k (%)|
Once you have a whole set of goals, goal-based planning can help you to prioritize and allocate resources across goals. A minimal retirement goal is pretty critical, but a second house downpayment is likely less so. It also helps you manage your risk according to the time horizon of each goal, rather than mashing them up together into one overall goal. There’s a neat paper on the optimality of that.
Avoiding the pitfall of mental accounting
Money is kind of the same (‘fungible’, in econo-speak). The $10 in your pocket are the same as $10 in your ‘baby’s college’ fund. But we sometimes don’t act that way. ‘Mental accounting’ refers to the fact that when we give labels to pots of money, and it can really change how we think about it.
That can be good… and bad. Imagine your are saving up for your child’s college fund, and have some money tucked away. At the end of the month your friends invite you to a concert, but you don’t have any spare spending money left. You could, of course, take some money out of your child’s college fund. It’s all just money, and you could replenish it when you got paid. But odds are, that will seem wrong to you, and you won’t do it. This is an example of how mental accounting can be a positive force for self control, helping us stick to our more virtuous, rational plans for the future.
However, change a detail of the mental accounts, and it can become harmful. Imagine that rather than paying for a concert, you need to pay off a credit card balance from repairing your car. In this case, you’ll end up paying higher interest than you could hope to earn in the college account. Because it feels wrong to withdraw from the virtuous college fund account, you might choose to pay the high interest. That’s what my friend Abby Sussman found in a recent research paper of her. This is definitely not rational.
The take-away is that while planning for individual goals can be very powerful in setting you up for success, you shouldn’t become too narrowly focused on individual goals. Always take a step back and check if the big picture still makes sense.