Think about where your pension pot is currently invested. Does your investment strategy match your investment horizon, your investment objectives and your appetite and tolerance for risk?
Time is an invaluable luxury. The amount of time at your disposal should be one of the major determinants of your investment strategy, influencing the level of risk you can assume and the types of investments that make up your portfolio.
If you are a long way from retirement…
Investing in assets with a higher potential for growth but greater risk may be a good idea.
Generally, the longer your time horizon, the higher the risk level you can assume, as you have the time to ride out any periods of short-term market volatility and recover any losses. Therefore, you could select a portfolio mix with a high allocation to equity investments.
Equity investments carry a higher risk than investments in cash and bonds in the short term, but over longer periods, equity investors have been historically rewarded for the extra risk they take, with equity investments outperforming cash and bond investments. In fact, as indicated by the graph below, if you were invested in global equities for any 1-year period from 1987 to 2018, you would have made money 71.9% of the times, whereas if you were invested for any 20-year period between these dates you would have made money in all cases.
Moreover, having a longer time horizon lets your investments take advantage of the growth potential of compounding to a greater extent. Compounding is a very powerful concept, since an investment’s returns are reinvested to generate additional returns over time, similar to a multiplier effect, increasing the value of an investment at a geometric rate.
Another issue to consider in the long term is inflation. Inflation is often referred to as the worst tax because its effects go unnoticed by most people. For example, an investment return of 2% before inflation in an environment of 3% inflation, will actually produce a negative return of -1% when adjusted for inflation. Investment returns should therefore at least keep up with the rate of inflation in order to increase your real purchasing power. Investments with higher potential returns are therefore better suited to outpace inflation.
As you are nearing retirement…
It’s often a good idea to reduce the risk in your portfolio to mitigate against sudden market movements when you need your money the most.
Generally, the closer you are to retirement, the less risk you should be willing to take in order to preserve the value of your pension pot. As your investment horizon shortens, you should adjust your portfolio in the direction of reducing the portfolio's level of risk. You can gradually reduce the allocation to equity investments and increase the allocation to bond investments and cash. Bond investments typically provide a lower potential return over the long run relative to equity investments, but they add stability to a portfolio's value since they tend to experience less pronounced short-term price swings.