Fortunes have been lost because typical investor psychology rarely aligns with investment success. Most investors can recount stories of losing money after excitedly buying at the top to later sell at the bottom or following the crowd into an overhyped stock. This is why astute financial advice firms are switching to goals based investing; an approach that embraces – instead of struggling against – investor psychology for superior results.
The key attribute of goals based investing is a focus on clients’ financial goals, rather than their risk profile, to determine their asset allocation. Finding out how a client approaches their finances and what they aim to achieve allows the adviser to put together an appropriate investment strategy that resonates with the client. Having a concrete plan that is based on the client’s personal goals, in addition to the trust and engagement that this approach creates with the advisor, means that the client is less likely to adopt herd mentality or make emotionally based financial decisions.
The focus on goal-making also works well with people’s tendency to practice mental accounting; this is where investors divide money across several buckets, depending on where the money came from and what they plan to do with it. For instance, people may place more value on money that they have earned, while spending a work bonus or winnings frivolously. Some buckets may also conflict; a common example is diligently saving a set amount each month while maxing out the credit card.
Goals based investing takes the inclination towards mental accounting and harnesses it by prioritising each goal from essential to aspirational, with a suitable investment strategy being devised for each goal; essential goals are given more capital and a more conservative asset allocation, while lower priority goals may take on more risk to boost returns. This approach mitigates loss aversion, as investors are happy to invest in riskier assets for certain goals if they can feel confident that their essential goals will be met.
Another facet of goals based investing that promotes positive investor psychology is the redefinition of risk; rather than measuring risk against an arbitrary benchmark, goals-based investing regards risk as a failure to meet the client’s goals within a specified time frame. Client meetings are no longer used to explain complex product features or market performance, which can confuse and alienate clients. Instead, advisors are able to check how the clients are progressing towards their goals and whether any lifestyle changes need to be incorporated into their investment strategies. Clients that understand their investments and how their decisions shape their financial future are more likely to stick with their long-term investment strategy rather than reacting to market ups and downs or chasing the latest hot tip.
Minimising capital volatility through active asset allocation, where capital is moved in and out of assets in response to market conditions, is another integral feature of goals based investing that fuels positive investor psychology. Since stressful market events often lead investors to make rash decisions, avoiding large losses helps them remain rational and focused. Clients can see progress towards their goals, irrespective of what the market is doing, which encourages them to stick with their long-term plan and ignore the market noise.
Goals based investing is a great match for positive investor psychology, resulting in happy clients and, in turn, a more profitable financial advisory business. To find out how to implement goals based investing into your business, contact Dynamic Asset today.