Step 1: Outline Your Goals

Start simply, by listing all of your goals.

Step 2: Prioritize Your Goals

The next step is to categorize each of your goals as either essential, important, or aspirational.

Step 3: Evaluate the Cost of Your Goals

Defining your goals as expenses involves just two simple calculations: How much you need and when do you need it? You can use the zero discount method (ie a very simple calculator) to quantify the total amount you need to save for almost any goal in the future. Simply figure out what it would cost today! If you have several years to save for a goal then you can just divide the number of years to figure how much to save each year. Nothing could be simpler!

Further thoughts on Setting Goals:

Intuitively, it might seem that funding essential goals should take precedence over saving and investing to achieve important goals and aspirational goals. Indeed, Maslow’s hierarchy of needs, is a starting point for organizing your goals, seems to suggest a natural ordering, funding essential goals first, then the important goals, then finally the aspirational goals. While this may be true, in many ways it is too simplistic.

Maslow’s expression of human needs does indeed resonate with people across all cultures, as shown by research based on the Gallup World Poll, an illuminating survey on well-being that queried more than sixty thousand respondents from 123 countries. This study also found that people prefer to work toward many kinds of goals simultaneously. Human needs are “like vitamins,” as one of the researchers explained in an interview with the Atlantic: “we need them all.”

So it goes with the Wealth Allocation Framework. You don’t need to have your safety net fully funded to begin the pursuit of an aspirational goal. It is a good strategy to start by funding your essential goals. But once you have a short-term safety net, you could also fund important and aspirational goals, thus building assets across your total portfolio simultaneously.

Step 4: Construct Your Net Worth Statement

Pulling together everything you own and everything you owe— your marketable securities, insurance policies, stock options, your home, and loans (such as a mortgage or student loans)—affords the opportunity to create a unified framework for managing your financial resources.

Step 5: Organize Your Net Worth Statement

This is the step where you organize your assets and liabilities across the safety, market risk, and aspirational risk buckets. In the Wealth Allocation Framework, Assets that provide safety and have the potential to hold their value in a market crash should be allocated to the safety portfolio. Assets that provide a risk-adjusted market return belong in the market portfolio. And assets that hold the potential for above-market returns, but also carry the potential for substantial loss of capital, should be allocated to the aspirational portfolio.

Step 6: Diagnostics

This is a reality check. If your goals are too financially expensive and you do not have the assets to back them up - then changing your investment strategy will not help. The reality of cash-flows dominates over speculative investment strategies. You will need to adjust the timing or the expenses associated with some of your goals or find ways to earn or save more money.

It is often easier to identify how much risk is too much. You can approach the issue from two perspectives. A subjective approach captures your personal attitude toward risk: How should you invest so that you can sleep well at night? Some investors are simply more willing to take on risk than others to achieve their goals. On the flip side, an objective approach to risk is defined by your personal balance sheet and your financial ability to absorb losses.

To be sure, there are many more risks than those measured by the standard deviation of a normal distribution, as we have seen. It is thus important to test your portfolio against those seemingly “rare” market disruptions that seem to occur with alarming frequency.

Some of these stress tests described in the article on Stress Testing Your Portfolio include Market Meltdown Test, Loss of Employment Test, Sustainability Test & the Aspirational Goals Test.

Annual Check-In: Reassess Your Goals and Risk Allocation

On an annual basis, it’s important to track how you are doing and to reassess your goals and risk allocation throughout market cycles and in the context of your current life stage. Simply put, you must evaluate how much security you need (safety portfolio) versus capital you are willing to risk losing completely (aspirational portfolio), and then put the rest in a well-diversified market portfolio.

Wealth is not an absolute number per se. Rather, wealth can and should be defined relative to your needs, wants and aspirations. This process should be repeated at least once a year - and has the advantage of enabling you to consider modifications to your lifestyle and expenses, if necessary.

When it comes to remaining financially healthy, adaptability and flexibility are key.