One of the first steps towards taking control of ones financial life is to list down all long-term and short-term goals that one needs funds for. The next step is to use a calculator to estimate how much one needs to invest for each goal independently. The results can often be frightening and sometimes even depressing. The total monthly investment amount needed to achieve all long term financial goals (let us call this Y) is often out of reach because of low salary, high expenses, liabilities and so on.
At the end of the day all one can do, at any point of time, is invest what one can. This often implies we either get rid of unimportant goals, decide to opt for full/partial alternate funding (eg. educational loan) or simply postpone some goals. While this is an important practical step, there is one more step you can consider before your choose to modify your long term goals.
The total investment required for long term goals can be optimized by integrating the goal investment process. The idea is not to worry about individual goal requirements and simply invest an amount 'X' each month. As the corpus grows, specific amounts required for particular goals are deducted as and when needed. Ideally, if X is the 'right amount' then the final corpus value will be equal to the sum required for retirement.
If X is lower than Y (total monthly investment amt obtained by treating each goal as independent) and is an amount which can be spared then we don't have to modify our goals. We have a reasonable chance of achieving goal targets even with a lower sum (X) provided other assumptions are reasonable. To aid the chances of getting X lesser than Y, we assume that the monthly investment X increases each year by some predictable percentage. This often makes a big difference and X can be significantly lower than Y. If one has liabilities (home loan etc.) at present and can afford to invest a higher sum a few years down the line, X can be decreased even further. So the idea of the exercise is to determine X: the lowest monthly investment required to achieve all your long term financial goals.
You can use the attached goal-investment-optimizer to determine if X is a low enough number for you. The model like any other must be used with precautions.
- It works with a single rate of return irrespective of durations associated with different goals. That is a goal 5 years away will not differentiated from one 20 years away. This is not practical because a 5 year goal can never have the same asset allocation as a 20 year goal.
- This means that the model is best used for truly long term goals. That is ones which are at least 10 years or more away.
- Just because we have obtained a X which is manageable does not mean we are guaranteed of success. Like with every calculator, success depends on how the parameters (inflation, rate of return etc.) entered turn out in real life.
- The model motivates us to start investing immediately with whatever we can. It is not a recipe for success.
- If we can invest more than X then we should definitely do so, unmindful of this optimization.
Features of the goal optimizer
- A retirement calculator which accounts for tax on corpus at the start of retirement in addition to tax on pension. These features are not available in my other retirement calculators
- Five goals in addition to retirement can be used for optimization.
- You can include two future investments (when current loans end)
- Excel Macro which implements the 'Goal Seek' function.
- Chenthil from Horus Financials pointed out this method to me first.
- Here is article which explains this idea to the investor: How a Financial Planner can add value through savings optimization?
- Here is one which explains this idea to an advisor: The Fallacy of Goal based Investment ‘Tagging’
- When I implemented this idea in Excel I was unaware of the 'Goal Seek' function. I used linear regression to determine X. This works fine but is not the best way of implementation. If you are interested the old version can be found here: Optimize Your Goal Investment Amount
- Arun Prakash pointed out that 'Goal seek' can be used to implement this in a simple way.