- Your investment profile
- Risk and volatility
- Return and performance
- Risk and return
- Investment life cycle
- Retirement planning
Your investment profile
Your investment profile will define the type of investor you are, taking into account your age, financial circumstances, investment goals and, most importantly, how much risk you feel comfortable taking or can afford to take. Risk is a vital element because as a rule, the more risk you can take on, the higher the potential returns you might make from your investments. These factors, together with issues such as tax and liquidity (how quickly you can access your money or convert your assets into cash if needed), will all help shape your investment profile. Your financial advisor can help you establish your investment profile.
A clearly defined investment profile will help you find investment solutions that meet your needs. Younger investors investing for their retirement several decades in advance can take greater risks with their money in order to achieve potentially higher returns or capital gains. They have a longer investment horizon and are in a better position to ride out the larger ups and downs of the market. Investors nearing retirement, however, may be better advised to favour less volatile, if also lower yielding, assets in order to reduce the risk of a sudden decline in the total value of their investments.
In general, investor profiles, which are often also called "risk profiles", can be divided into three major categories:
Conservative (low risk)
Capital growth is not a priority and cautious investors seek stable investments that will gradually grow in value and are not prone to high volatility. With the majority of its assets invested in bonds and cash instruments, a conservative portfolio should deliver a steady income stream and moderate capital growth.
Balanced (medium risk)
With a somewhat more volatile portfolio, you can expect good if not necessarily exceptional capital growth over the long term. Although you will experience some market fluctuations, a rollercoaster ride is rather unlikely under normal market conditions. Frequently, the assets in a balanced portfolio include a mix of shares and bonds from stable companies. A small proportion of the portfolio may even be invested in riskier assets in order to deliver better capital growth.
Dynamic (high risk)
Dynamic investors are prepared to expose their portfolio to greater risk and accept higher volatility in order to maximise capital growth. Your investment portfolio could even include riskier shares, such as emerging market equities or shares of young companies, and as a rule, contains a higher proportion of shares than bonds.
An investor's attitude toward risk is central to the way he or she makes investment decisions. It will strongly influence not just their likelihood of losing money but also the extent of the returns their investments are expected to generate. For most investors the term "risk" focuses primarily on the possibility that their investments might either incur a loss ("downside risk") or fail to make a profit ("upside risk"). A key question that investors must ask themselves is how they might respond to an unexpected fall in the value of their investments. Only then can they take decisions on investments that match their risk comfort levels.
Risk and volatility
Risk is often viewed and measured as the level of price volatility recorded by an asset or investment fund – in other words, the range within which its price fluctuates. Short-term investors may find volatility a greater risk than those with a long-term investment horizon because under normal market conditions, price fluctuations frequently balance themselves out over the long term.
The volatility of an investment fund’s value will reflect that of the assets in which it invests. Analysing a fund’s prospectus provides information about how volatile a fund has been in the past – although this is never a certain indication of the future volatility and performance of the fund. By reading a prospectus, you can also find out whether growth coincided with strong price volatility or was achieved continuously and in steady steps. Two funds may deliver the same level of capital growth and income, but have taken very different routes to do so, thus demonstrating significant differences in volatility.
An investment fund's volatility can derive from a number of different sources, such as fluctuations in the price of a particular share or in the currency in which the price is measured. Highly-focused investment funds may experience greater volatility because they contain fewer securities, so the performance of a single investment may have a greater impact on the fund as a whole. However, it is important to remember that volatility can also have a positive effect because it not only can bring greater risk but higher potential returns as well.
Return and performance
The return generated by an investment fund is made up of growth in the value of the fund’s assets plus any income it may distribute to shareholders (many funds retain this income and reinvest it in additional assets). The fund’s performance is measured by the return it delivers over a particular time period. The performance can then be compared with that of funds with similar investment policies, or with a benchmark such as a stock market index. Investors can analyse historical data about a fund’s performance to decide whether it is likely to meet their return targets. However, it should be remembered that past performance is no guarantee that those returns will be repeated in the future.
Risk and return
Risk is an essential part of investing in an investment fund – because without risk, the assets you have invested in will generate little return. If an investor is willing to accept a higher level of risk, this often means that he or she can achieve a greater potential return on his or her investments. By contrast, investment funds that invest in less risky assets can be expected deliver lower returns.
Equity funds that invest in shares with high growth potential may also carry the risk of substantial losses. As a rule, the potential return and risk is lower for shares of established companies that deliver a consistent growth rate and returns. It should be noted that the overall risk of an investment fund is carefully monitored. Fund managers operate within established risk limits to ensure that the risk and return targets correspond with the profile of the investment fund – although there is never a guarantee that market movements will not have unforeseen consequences for the fund’s investments.
Diversification is a key tool for risk management. By investing in a wide variety of individual securities or asset classes the risk of each investment is spread across different sectors, markets, countries, regions, and so on. The degree of diversification within a fund is tailored to meet the relevant performance objectives and investment policy. Risk management is an integral part of the investment process as fund managers seek to ensure that their selection of assets will enable them to meet the fund’s performance objectives.
Details of a fund’s expected levels of risk exposure and return objective will be explained in the fund’s Key Investor Information Document as well as in its prospectus.
Investment life cycle
The first step in developing an appropriate investment strategy is to be clear about what your financial goals are. While for most people the single most important long-term goal by far is having financial security for retirement, many investors set other investment goals, such as financing trips, home improvements, paying for their children's education or buying luxury goods. One additional objective that does not fall within a particular time frame is creating an emergency fund that will be constantly available for life’s unexpected twists and turns. Choosing a flexible type of investment, through savings plans for instance, allows investors to increase their regular contributions when they have more disposable income and cut back if times are more difficult.
Your age and investment profile have an enormous influence when choosing investment funds. Your needs and goals change significantly over the years. At the start of your career you may be saving for the down payment on a mortgage or car – you may not have much disposable income, but your expenditure will also probably be low. As you get older and approach the peak of your earning power, you may have a mortgage to pay off and a family to feed. As you approach retirement, your financial commitments and priorities will shift once again as the desire for regular income becomes more important than the need for strong capital growth.
As your financial situation changes it is essential that your capital investments are also adjusted to reflect your revised investment needs. Regular reviewing your investments with your financial advisor will ensure that your portfolio remains constructed in line with your circumstances and requirements.
For most people, planning for retirement is the most important reason to save and invest. Ideally this process should be spread over your entire working life. If you start saving for retirement early in your working career, your investments are less vulnerable to the ups and downs of the market cycle. Long-term, regular investing also allows you to benefit from the cost average effect, where by regularly investing the same amount over a long period of time (e.g. several decades), you can reduce or avoid the need to worry about paying expensive prices for assets purchased at the peak of a market boom, because you will also be buying other shares cheaply when prices are depressed. In other words, you buy fewer shares when prices are high and more when prices are low.
Investment funds are a useful tool for retirement planning because of their diversity, flexibility and liquidity. Fund units or shares can be bought and sold easily, without high costs and at fairly short notice. The vast choice of funds available in the European market (a large proportion of them based in Luxembourg) allows you to build a portfolio of investments with varying degrees of risk and return. Over the retirement saving period, the degree of risk and return in the investor’s portfolio can be adjusted to match their changing profile and stage of life.
In general, financial advisors recommend investing in a larger proportion of assets that carry a higher risk but promise higher returns when you are young and then positioning your portfolio more conservatively later on as you approach retirement. This should minimise the risk that a market disturbance could significantly reduce the pool of money you have available to use during your retirement. As they reach retirement age investors may want to switch part of their portfolio into investment funds that pay out dividends or interest on bonds. This would provide a regular income stream at a time after you are no longer earning a full salary or not earning a salary at all.
A popular form of investing in investment funds for retirement is through unit-linked life insurance or pension schemes, for which Luxembourg is also a European leader. For example, the value of a unit-linked life insurance policy depends on the performance of the investment fund in which it invests. Unlike with direct investments in investment funds, investing in unit-linked plans generally entails restrictions on investors' ability to cash out the assets in their life policy or pension scheme before reaching retirement age, or even financial penalties for doing so. Therefore, you should always take professional advice, including advice on tax-related matters, before investing in a unit-linked pension scheme or life policy.
Rules and tax regulations for investments made as part of a retirement plan vary greatly according to the investor’s country of residence. In some cases there are tax incentives for retirement investments at the time the investment is made but the eventual retirement income is taxed, whereas in other countries it is the other way round. Most investments made as part of an approved retirement planning scheme benefit from some form of tax benefit, whether at the time of the initial investment, as the regular contributions are paid in, or when the benefit is drawn on.