Creating goal-based portfolios help you stay focused on achieving your objectives without taking additional risks. If you have three life goals to pursue now, you should have three different goal-based portfolios.

But what if you are unable to contribute enough capital to all the portfolios? Or, if you face shortfall in one of your goal-based portfolios? In this article, we discuss how to prioritise your goals and bridge the investment value gap, if any.

Allocation criteria
Your investment choices should be driven by your goal priorities. Why? The goal will rank as high priority only if achieving it is important to you. What if you experience losses in your investment account in the next three-five years to such an extent that it becomes difficult for you to accumulate, say, Rs.1 crore by 2025? The fear of facing a shortfall will force you to be conservative in your investment choices when you create the goal-based portfolio.

As a rule, the risk you take when investing is a function of your goal priority. So, higher the goal priority, lower your ability to take risk. And lower the goal priority, higher the ability to take risk. Logically, your high-priority goal-based portfolio should have more allocation to bonds than equity, whereas your low-priority goal-based portfolio should have more allocation to equity.

So, you should set aside more money to meet your high priority goals; more bonds in your portfolio mean that you have to contribute more investment capital, as bonds have lower post-tax expected returns compared to equity.

How will you decide whether a goal is high priority? The test is whether you can postpone a goal when you face a shortfall in your investment account. If you cannot, the goal is high priority. Consider your child’s college education fund. You have to accumulate enough money in this account by the time your child turns 17. This goal is high-priority because it cannot be postponed even if you face a shortfall in your investment account. You can, on the other hand, consider postponing your retirement, if required. Hence, accumulating wealth in your retirement account is not necessarily a high-priority goal..

Short-term goals (those that have an initial time horizon of five years or less) are not high-priority if they can be postponed..

A short-term goal that improves your family’s level of happiness (like going on an exotic vacation) should follow in ranking to your high-priority goal.

Bridging the gap
Besides driving your investment choices, ranking goals helps you manage your investment value gap. The difference between the target value and the accumulated value in your goal-based portfolio is the investment value gap.

How will you fill any value gap in your high-priority goal-based investment account? First, you can use the hierarchy-constrained fungible rule, whereby you can transfer investments from your lowest priority goal to your highest priority goal, but not the other way.

You may sometimes have to transfer money from a short-term goal to your high-priority goal to bridge the gap; this could happen when your high-priority goal-based investment account experiences a value gap and you have five years or less to achieve the goal. Second, you can use your self-occupied house (home equity) as collateral to borrow money from the bank.

This is especially useful when there is a large shortfall in your child’s college education account. So, achieving your goals involves two steps. One, priorities your goals and create goal-based investment portfolios. Two, create a contingency plan to fill any investment value gap.

B Venkatesh
This article was published on January 31, 2016, in Business Line (The Hindu)