In a world where you are presented with numerous investment opportunities be it in financial assets, real estate, arts and collectibles, or private businesses how do you decide which investment is the best one? How do you decide how much to allocate toward each investment? Finally how do you decide which investment did as well as it should have?
What happens for many people is that they usually do a simple calculation on how much money they can make on a particular investment all either in their head or by jotting it down, while in a very implicit way also assessing the potential risk associated with that investment in their mind.
A more practical way of investing would be to first identify and prioritize the actual reason or goal for why you are investing.
After all when you invest, you are putting to risk money that you’ve more than likely have worked hard to accumulate, and probably has come with some trade-offs such as work/life balance. You are also sacrificing or cutting back on your current spending, just so you can have ‘more' money in the future.
So to justify this decision in your mind, the pleasure of whatever amount you can potentially going to have in the future, should outweigh the trade-offs you’ve endured as well as the pleasure of spending it right now.
The process of identifying and prioritizing your financial goals and the anticipated expenses to fund those needs; makes this justification for investing much easier. No longer you will have an implicit goal or one that is just in the back of your mind, where you randomly or emotionally decide on when and how much you need to invest for it.
No longer you will allocate some money to a particular investment only because you got a call from a broker about a special opportunity. More importantly it will give everyone vested in the outcome, which may be your spouse and/or your advisor a much better idea of why you are investing.
After you’ve enumerated your goals, the next logical step would be to establish a set of personal benchmarks needed to reach your goals. These personal benchmarks will include both an average annual returns that your investments needs to grow by to reach your goals, as well as potentially any additional regular contribution needed on your part to improve your chances of funding your goals.
The use of personal benchmarks in goal based investing is in direct contrast to typical index based investing or performance based investing. In index based investing individuals compare the performance of their portfolio with one or a blend of several indexes from a long list of indices created by various companies. Usually it is either the S&P 500, the Dow, or maybe the MSCI World Index or one of the more esoteric ones.
When using goal based investing you do not care if the S&P index or the Nikkei index or for that matter someone that you know was up 15% or down 15% in a given year. You only care about your own personal benchmark and how and why your portfolio exceeded or underperformed that benchmark and what adjustments needs to be made going forward.
The final step would be to use your goals along with potentially how much loss of principal you can handle or what is commonly referred to as risk tolerance to create a diversified portfolio.