Risk and reward: the secret to understanding your investment profile
If you are a member of a Defined Contribution fund, as most South African fund members are, the investment return that you earn on your fund contributions has a direct impact on how much money you will have as pension one day. As a rough guideline, the consensus is that you should be able to enjoy a reasonable retirement if your pension income is equal to 70% to 80% of your total salary just before retirement.
How can you tailor your investments to meet this objective? Let’s consider a few basic principles.
Investment is all about balancing risk with reward.
Higher-risk investments usually lead to greater rewards, i.e. higher returns.
When you are young, you have many years to recover if your investment has a bad month or even year.
This means that younger members can afford more risk.
Conversely, older members need to protect their investments from a bad month (or year) just before they retire – they do not have time to recover from their losses.
Simply put, the younger you are, the more your retirement savings should be invested in risky asset classes, such as shares, also known as equities.
And the older you are, the more you should invest in less risky asset classes, such as inflation-linked bonds and the money market.
From the above summary, it’s clear that your investment risk profile is directly linked to the number of years you have left before you retire.
However, there are other, more personal attributes that may affect the level of risk you are willing to take. If you are aware of these, it will help you to make more objective investment decisions.
Are you the life and soul of the party? If you love being around others, and you consider yourself an extravert, you are likely to have a higher risk tolerance, which gives you the opportunity to see higher returns. However, you face the danger of taking too much risk, or falling for ‘get rich quick’ schemes. It’s important to let your head be in charge, and not your heart. Seek expert advice if you are unsure.
Are you the person everyone turns to in a crisis? If you tend to go the extra mile at work, and you are the one whom others trust to get the job done when the going gets tough, then this is likely to be you. You are responsible and organised, and you plan head. However, you may be overly cautious and afraid of risk, which might lead to your losing out when you can afford to take some risk.
Do you worry a lot? You experience high levels of stress and sleepless nights, and you often second-guess yourself, or struggle to make decisions at all. You would likely benefit greatly from obtaining a professional opinion when it comes to your investments. Of course, everyone benefits from expert advice, but you especially will experience greater peace of mind by following this route.
Are you a ‘glass half full’ person? You are an optimist, and you try to see the best in every person and every situation. You may trust people easily, and like the extravert above, you run the risk of being swindled. Your intentions may be good, but there are many villains out there who will try to take advantage of your good nature. Be sure to never make any decisions without doing your homework.
In conclusion, if you know yourself, you can make the most of your strengths and minimise the impact of your weaker traits. Combined with knowledge of your investment time horizon, you are well equipped to make sound investment decisions.