How to Choose the Right Investment for You - dummies

By David Stevenson

After taking a look at your present circumstances, investment goals and risk attitude, you want to ensure that you pick the appropriate financial products. Fully understanding the risk/return trade-off is central to these decisions for investors in the UK and around the world.

Of course, pigeonholing individual investors is fraught with problems but experience shows that certain generalisations apply about how different people’s risk/return trade-offs impact on investment strategies. There are three rather crude but useful categories of investors: low risk, middle of the road and adventurous.

Operate as a low-risk, cautious investor

Here are some strategies that characterise the average lower-risk investor:

  • Absolute returns: Even low-risk investors like to think that they can make a positive return, which explains why so many are attracted to the idea of absolute returns; that is, making money in all markets, whether those markets are rising or falling in value.

  • Bonds: Bonds are likely to be a favourite in terms of asset classes, simply because they tend to be less volatile and produce income. Crucially, the promise to repay that’s implicit within a bond structure (at redemption) is likely to be very attractive.

  • Capital preservation: Lower-risk investors hate losing accumulated capital, and so tend to want to preserve their capital no matter what. Alternative assets, such as gold, that speak to capital preservation may make a fleeting appearance in the cautious investor’s portfolio.

  • Currency exposure: Currency exposure probably becomes less of an issue for cautious investors. They usually want to limit their portfolio of investments to those denominated in the currency of their home base.

  • Equities: Shares are likely to be much less attractive because they’re regarded, rightly, as fairly risky. If an exposure to shares does exist within the portfolio they’re likely to be blue chip stocks with strong balance sheets and sensible valuations.

    No intrinsic reason exists as to why cautious investors shouldn’t be interested in more sophisticated styles of investing that look to limit downside risk by hedging.

  • Income: This is critically important to many cautious investors largely because as they approach retirement they tend to turn their attention to eking out a monthly income from their accumulated savings.

More cautious investors need to think long and hard about their attitude towards three key issues:

  • From where are they going to derive their future positive returns?

  • Just how much bond exposure can they stomach?

  • How important is capital preservation?

Choose products for the middle-of-the-road investor

Unsurprisingly the world of investing is full of funds that are marketed for perceived middle-of-the-road investors. The names attached to these funds vary but they probably include a mention of being balanced. Here are the main strategies and so on of middle-of-the-road investors:

The key is to balance growth potential and capital preservation, which usually means balancing shares and bonds in the portfolio mix:

  • Shares provide a core enhanced level of income through dividends and also provide the main potential for capital growth.

  • Bonds provide the core of any future ‘guaranteed’ capital return.

  • Alternative assets provide occasional income, which isn’t crucial unless investors have some specific needs such as funding their children’s education.

Be an adventurous investor

Most professional advisers and investors probably prefer the ambitious adventurous investor, otherwise known as growth-friendly (after all, more investment activity tends to translate into more trading costs). These investors tend to be more optimistic about the future, more willing to take risks and more willing to be active in capitalising on opportunities.

In no particular order, adventurous investors are likely to have the following characteristics:

  • A focus on capital growth.

  • A willingness to make losses in the short term.

  • Less concern about income.

  • An interest in complex strategies that involve options, hedging and derivatives.

  • A global focus, including in their currency exposure.

  • A concentration on shares as their portfolio’s core component.

  • An emphasis within the share component of the portfolio on growth opportunities.

  • A great interest in alternative assets.

For adventurous investors, three key concepts constantly lurk in the background:

  • A willingness to be tactical, which means perhaps changing a core holding every few weeks or months, even if only by a small amount.

  • The possibility of using gearing, using someone else’s money to make an investment, to amplify returns.

  • A willingness to think outside the box, go for global assets and be alternative.

One challenge can be that you end up overtrading (so incurring extra costs) and believing too much in your own market-anticipation skills. You start thinking that you’re an investing sage and can successfully divine the future twists and turns of the market.