There are a variety of reasons why you might choose to invest. These range from medium-term goals such as your children’s future education expenses or building up a house deposit, to longer-term goals such as retirement. To manage these competing interests, you need to look at each of your financial objectives both individually and as a whole.
“Many people focus on their financial goals in isolation, but these goals are often interconnected so what they need is a financial plan that brings everything together and ensures that their overall financial planning is on track,” says Pat Connolly, certified financial planner at Chase de Vere. “For example, somebody may have a long-term goal of saving for retirement but also a medium-term goal of saving for their children. If their retirement planning is on track they may be able to save more for their children, but if their retirement planning is behind schedule they may have to focus more on that and less on other priorities.”
It is a good idea to assign money to all the financial goals you would like to achieve. But often, coming up with a plan for your personal finances may be about prioritising your goals – especially if you cannot afford to put money towards all of them.
For example, a younger person who is just starting to build their wealth might be able to save £200 a month. If they are auto-enrolled by their employer into a pension, they may decide to use this as their only form of retirement saving for now. So instead of also saving that £200 into their pension, they could use it to build up an emergency cash fund of between three to six months’ salary, suggests Danny Cox, chartered financial planner at Hargreaves Lansdown. Once that goal is achieved they could then save £200 a month towards a house deposit by investing in a Help to Buy or Lifetime individual savings account (Isa), which offer government bonuses towards property purchases.
Other individuals may find themselves temporarily needing to prioritise paying off a mortgage over concentrating on retirement funding, for example to pay off an interest-only mortgage. But Petronella West, director, private clients at wealth manager Investment Quorum, says even when some goals take precedence over others you need to you pay attention to your wider circumstances.
“Someone might think, for example, I’ll use my pension to pay off the mortgage [as from age 55 you can take money flexibly from your pension],” she says. “But you would be taking money out of a pension that is growing tax-free and putting it into a taxable zone.”
And taking a large sum without paying heed to the tax consequences could have a knock-on effect on your income in retirement.
So to keep abreast of your financial and investment goals, you should conduct regular reviews of your personal finances. Generally, a review at least once a year is considered good practice. But you should also review your situation whenever your personal circumstances change.
When to save and when to invest
Recognising when it is appropriate to invest and when it is better to save money in cash to meet your different objectives is very important. Short-term goals that you are aiming to achieve over the next one to five years, such as a buying a new car or next year’s holiday, are better suited to cash savings. This is because investing in the stock market over short timeframes exposes you to potential volatility, and if the market falls you will have little time to claw back any losses.
Many financial planners suggest five years as the minimum time horizon if you put your money into risk assets such as equities. And Martin Bamford, managing director of independent financial adviser Informed Choice, says: “I would say that cash is the answer for anything under a seven-year timeframe. People get disappointed to hear that, as cash rates are so low at the moment and savings accounts are offering paltry returns, but compared with the alternative – volatility – cash’s security is underrated.”
Mr Bamford also believes that increased life expectancy means the goal posts for what is considered short, medium and long-term have shifted – especially for younger investors. This is because someone in their mid-20s today might spend 40 to 45 years working and then have 20 to 30 years in retirement. So those in their 20s and 30s may want to consider medium-term objectives to be between 10 and 30 years, and long-term as anything over 30 years.
Asset allocations for different time horizons
It makes sense to have different pots of money to meet your different goals. Mr Bamford says: “Having different pots of money is a more sophisticated way of allocating financial resources to different objectives.”
Deciding how much to put into each pot and where you invest the money will depend on how long you plan to invest for. Generally, the longer you are investing for, the more risk you can afford to take. But other factors will also influence your asset allocation.
“Asset allocation depends on your goals, your attitude to risk, your capacity for loss [and market conditions],” explains Ms West. “In an era of low interest rates, where we’ve got inflation close to 3 per cent, if you don’t take risk you won’t beat inflation. So equities are where you’ll get the real return, but they are also the most volatile. You also have to weigh up the risk of holding bonds. Yields are very low on most bonds and with interest rates going up there is the risk of capital loss.”
Because of the risks surrounding bonds Ms West is making sure that any bond exposure in her clients’ portfolios is short-duration. Short-duration bonds are less sensitive to changes in inflation or interest rates.
But although fixed income incurs these risks, Mr Bamford says that diversification is important for investors with shorter-term investment horizons. So he suggests that if you have an investment period of around 10 years you hold bonds, as well as commercial property, cash and shares. The exact asset allocation will depend on how much risk you feel comfortable taking.
Mr Connolly suggests that money for financial goals you hope to achieve within five years should be held in cash. If you are investing for between five and 10 years he suggests holding a combination of cash and shares, for example:
Mr Cox suggests that investors with a five to 10-year horizon stick to more conservative UK equities, and UK equity income funds are a good way to access these. See this week’s Big Theme and the IC Top 100 Funds for suggestions on these.
But if you have a longer timeframe you could also consider global equities, for example, via emerging markets funds.
Mr Connolly says that if your investment time horizon is 10 to 20 years you could invest primarily in shares, such as:
And he says an investment time horizon of over 30 years should also probably be heavily focused on equities, such as:
“It’s also good to have a clear expectation of what your portfolio is likely to return,” adds Ms West. “For example, you need to be aware that you’re not going to get much more than 4 per cent a year with 50 per cent in bonds and 50 per cent in equities.”
And certain types of tax wrapper can be helpful for certain objectives. For example, pensions are a great way to save for retirement, but are not well suited to shorter-term goals because you cannot access the money in them until age 55. But most Isas can be accessed before that age. No further tax is payable on income or interest from investments held within them, and when you sell investments in an Isa it doesn’t incur capital gains tax (CGT).
“The longer you are invested, the more important wrappers such as Isas and pensions become,” says Mr Bamford. “In pensions, any pound saved is boosted by initial tax relief and the money is also growing in a tax-free environment. If you have got those allowances it can help to spread your money between different tax wrappers. The most successful outcomes we see when people get to retirement is with those that have lots of different pots in different wrappers, as this gives them more options.”
What to do when you are nearing your goal
When you set out on a medium or long-term investment objective, your focus is typically on capital growth. However, when you get closer to needing the money, capital protection becomes as important as capital growth because you can’t afford to lose what you have made.
“In this circumstance, it often makes sense to reduce exposure to equities and increase weightings in other asset classes such as cash, fixed interest and property,” explains Mr Connolly.
For example, if you have 10 years remaining of a 30-year retirement investment strategy, you could change your asset allocation to 63 per cent equities, 25 per cent fixed interest and 12 per cent property.
And the nearer you get to your goal deadline, the more you need to think about how you will withdraw your money.
“Nobody could have anticipated that the market would drop like a stone at the start of this year and then recover, and if you had withdrawn money in March you would have risked taking it out at the most volatile time,” says Ms West. “So, you need to plan your withdrawls between one and three years ahead, and start harvesting the profit bit by bit [in advance of your end goal].”
Mr Bamford adds: “Decide at the outset what your strategy for drawing down the money will be, because as it gets nearer to the time you do this, you will probably start paying attention to market noise. If the market is falling or people are saying it might fall, you might make emotive decisions. So, on day one of your saving period, set a date on which you’re going to draw a certain amount of money – regardless of whether markets have gone up or down.”
If your goal is retirement, there are various options for switching from a capital growth to an income focus.
“A traditional lifestyling investment approach involved derisking your pension ahead of your retirement – ie moving out of equities into cash or bonds,” says Mr Cox. “But that kind of lifestyling is pretty redundant for most people these days, as most no longer use their whole pension pot to buy an annuity. But the lifestyling approach is still the default used by most pension schemes.”
Instead of following the lifestyling route, you could keep the majority of your self-invested personal pension (Sipp) invested, and draw down a flexible income or take lump sums when you need income. However, although flexi-access drawdown has benefits, it incurs risks – the most serious of which is running out of money in old age. See How to make your retirement pot last with income drawdown on the Investors Chronicle website for more details.
This is in contrast to when you buy an annuity, which gives you a guaranteed income for life.