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Investment - Factors that Affect Investors' Needs
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
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The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
" "
Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
" "
On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
Investors — whether individual or institutional — have distinct investment objectives. Key factors that are universal to all investors, but that will vary in amplitude for each investor, include the following:
Required return
Risk tolerance
Time horizon
Investors may also have distinct needs in relation to liquidity, tax concerns, regulatory necessity, compatibility with particular religious or ethical standards, or other unique conditions. Investors’ situations and needs change over time, therefore it is vital to re-evaluate their needs at least annually.
Required Return
Investors differ in how much return they need to accomplish their aims. The rate of return required, before and after tax, can be estimated using some aim for future wealth or portfolio value.
For example, depending on an investor’s age, initial investable assets, planned savings, and tax situation, an adviser may calculate that a 6% rate of return before tax on investments is required for the investor to reach his or her goal of having a EUR500,000 portfolio value at retirement.
If the desired rate of return seems unlikely to be obtained, the investor’s goals may have to be updated or other criteria, such as the quantity of savings, may have to be adjusted.
An investor may use a total-return perspective, which sees no distinction between income (for example, dividends and interest) and capital gains (i.e., rises in market value). The source of return — changes in value or income — does not matter to a total-return-oriented investor. Alternatively, an investor may discriminate between income and capital gains, seeking income for present consumption and capital gains for long-term requirements.
The return criterion, particularly for a long-term horizon, should be defined in real terms, which involves compensating for the effect of inflation. This modification is vital because it preserves the emphasis on what the accumulating portfolio will give at the conclusion of the time horizon. An increase in value that simply equals inflation does not give a client more spending power.
The investment manager or adviser has to be comfortable that the investor’s targeted rate of return is possible within the related limits. Most clients would desire high returns with little risks, but few investments offer this expected profile. The adviser or manager has a role in counselling the customer.
Typically, higher levels of expected return will require higher amounts of risk to be taken.
Some investors will prefer to invest in hazardous assets because they require high levels of return to fulfill their goals, but the potential implications (the negative risks) connected with this strategy need to be addressed.
Other investors will have previously collected sufficient assets that they do not require significant returns to fulfill their goals and can choose a lower-risk approach. This condition could be the case for a pension plan that has a high funding level, indicating that its assets are adequate, or almost sufficient, to satisfy its liabilities.
Other individuals that have gathered considerable assets may choose to invest in riskier assets since they are capable of absorbing the risk and are able to fulfill their goals even if they experience losses.
Investors, particularly individual investors, will frequently modify the proportion they invest in different kinds of assets over time as they age and their circumstances change. Individual investors with defined contribution pension plans can also alter their investments inside the defined contribution plan.
Risk Tolerance
Investors often have restrictions on how much risk they are willing and able to take with their investments. As discussed earlier, there is a connection between risk and return. Typically, the bigger the predicted return, the higher the risk connected with that return. Equally, the more risk taken, the bigger the projected reward. The investor’s risk tolerance is a result of their ability and willingness to take risk.
g
The ability to assume risk relies on the condition of the investor, such as the balance between assets and obligations and the time horizon. If individual investors have significantly more assets than liabilities, any losses that occur from risk taking may not impact their lifestyle. If investors have a lengthy time horizon, they have more freedom to adapt their circumstances to cope with losses by saving more or waiting for markets to rebound, although recovery and its timing cannot be assured.
Willingness to take risk is tied to the investor’s psychology, which may be examined using questionnaires. desire to take risk is frequently considered of as a more relevant issue for individual investors, but even those who oversee institutional investments will have risk guidelines within which they must work and that help define their ability and desire to take risk.
" "
Some institutional investors, such as insurance companies and other financial intermediaries, may also face regulatory constraints on how much risk they can take with their holdings.
There may be scenarios in which an individual investor’s willingness to accept risk and their ability to take risk diverge. In such cases, the investment adviser should counsel the investor on risk and assess the right level of risk to take in the portfolio, taking into account both the investor’s ability and willingness to take risk. The lowest of the two risk levels should be the risk level adopted.
Time Horizon
The investor and adviser must be clear on the time horizon for the investments. Some investors will need to access money from their portfolios in the immediate term, but others will have a much longer time horizon.
" "
On the institutional side, for example, a property and casualty insurance company that expects to have to meet claims in the next few years will have a short time horizon, whereas a sovereign wealth fund that is investing oil revenues for the benefit of future generations will have a long time horizon, possibly decades.
Someone who is intending on buying new house, new automobile or paying for education in two or three years would have a short horizon which is a fraction of his investment.
A 20 years old investing for retirement will have a lengthy horizon and mehr than 40 years.
The investment horizon has crucial consequences for how much risk can be taken with the portfolio and the level of liquidity that may be necessary. Liquidity is the ease with which the investment can be converted into cash. For example, an illiquid private equity investment with an anticipated payout in 10 years would be unsuitable for an investor with a 5-year investment horizon.
Both institutions and people must also consider longevity risk, which refers to the potential that life expectancy surpasses expectations and resulting in greater-than-expected cash flow needs in the future.
INDIVIDUAL LONGEVITY RISK
Individuals planning for retirement face the risk of outliving their assets.
INSTITUTIONAL LONGEVITY RISK
Institutions, such as pension funds and insurance firms, are exposed to high longevity risk when guaranteeing guaranteed lifetime payments. As medicine develops and wealth levels rise, longevity risks will increase and induce more adoption of risk mitigation techniques (e.g., expenditure modifications, insurance risk pooling) among individuals and institutions
Investors with longer time horizons should be able to assume greater risk since they have more time to adapt to their circumstances. For example, they can save extra to compensate for any losses or returns that are less than projected.
History shows that, over time, markets go up more often than they go down, thus an investor with a longer time horizon has greater chance to build good return performance.
Longer-term investors are also better equipped to wait for markets to rebound from a period of bad performance, but recovery cannot be guaranteed.
Liquidity
Investors vary in the amount to which they may need to remove money from their holdings. They may need to make a withdrawal to fund a specific purchase or to build a monthly revenue stream. These needs have ramifications for the types of investments chosen. When liquidity is required, the investments will need to be convertible to cash relatively fast and without too much expense (keeping transaction costs and variations in price low) when the cash is needed.
Individual Investors
An person may require that a portion of the portfolio be liquid to pay unanticipated needs. In addition, the individual may have known future liquidity requirements, such as an anticipated future expenditure on children’s schooling or retirement income demands.
Institutional Investors
For an institution, the liquidity restriction often reflects the institution’s liabilities. For example, a pension fund may expect to begin suffering net cash withdrawals at a given time in the future (i.e., when pension payments exceed new contributions to the plan) and will need to sell off some portfolio investments to fulfill those demands. It needs to hold liquid assets in order to do this.
Regulatory Issues
Some sorts of investors have regulatory restrictions that apply to their investments.
For example, in some countries and for certain types of institutional investors, there are restrictions on the proportion of the portfolio that can be invested overseas or in riskier assets, such as shares. Regulations on the holdings of insurance companies are often substantial to protect policy holders.
Taxes
The tax situations of investors differ. Some categories of investors are taxed on their investment returns, and others are not. For example, in many nations, pension funds are excluded from tax on investment returns. Furthermore, the tax treatment of income and capital gains can differ. It is crucial for investment advisers to evaluate an investor’s tax situation and the tax repercussions of alternative investments.
Investors should care about the profits they make after taxes and fees since that is what is available to spend. For example, an investor who is subject to higher tax on dividend income than capital gains will normally choose a portfolio of assets targeting capital growth (i.e., from an increase in value of shares) rather than income (i.e., dividends from shares).
Individuals may also face various tax circumstances for different components of their wealth.
For example, an individual may opt to maintain some assets in a pension account if income and capital gains on assets held in a pension account are tax-exempt or tax-deferred. The investor may choose to hold assets expected to generate capital gains in a taxable investment account if capital gains are taxed at a lower rate than income. Where assets are held can considerably affect an investor’s after-tax profits and wealth building.
Unique Circumstances
Many investors have special requirements or limits not reflected by the traditional categories addressed thus far.
Some investors evaluate how environmental, social, and governance concerns (together known as ESG investing) impact the financial performance of possible investments. Beyond assessing ESG risks associated with an investment, some investors expressly pursue an impact investing approach, which targets investments having beneficial and measurable societal or environmental outcomes (e.g., using social or environmental measures).
Some other investors directly incorporate religious or ethical preferences and exclusions into their investment preferences. For example, some investors may not participate in traditional debt securities because they do not believe they accord with Islamic law.
Investors may also have special requirements that come from the type of their broader investment portfolio or financial circumstances. For example, an individual who is employed by a corporation may seek to limit investment in that company. Limiting investment in securities issued by their workplace would help the employee reduce single-company risk and acquire broader diversification.
Interestingly, many individuals are actually tempted to expand their holdings in their employers’ shares on the grounds of loyalty or familiarity, despite the danger that this strategy carries. Such a strategy can have significant ramifications if the company fails or its financial position falls. For example, many employees of Enron Corporation, a US energy corporation, not only lost their employment but also suffered huge investment losses when Enron went bankrupt.
Institutional investors may also have unique and specific criteria as a result of their objectives and circumstances. For example, a medical foundation may desire to avoid investing in tobacco stocks because it considers encouraging tobacco smoking is antithetical to its objectives of improving health.
Behavioural Finance Considerations
Behavioural finance aims to understand and explain actual investor behaviour, in contrast to theorising about investor behaviour. It varies from traditional (or standard) finance, which is founded on assumptions of how investors and markets should behave. Behavioural finance is about understanding how individuals make decisions, both individually and collectively.
By understanding how investors and markets behave, it may be able to adjust or adapt to these behaviours in order to enhance investment outcomes. In other words, the way investors think and feel affects the way they behave while making investing decisions. Some of these actions are implicitly impacted by prior experiences and personal beliefs to the extent that even competent investors can break from logic and reason.
These factors, which can be classified and characterized as behavioural biases, can alter the way risk is seen and how risk is understood by someone trying to determine a person’s risk tolerance.
Examples of behavioral biases that effect investment decision making vary by individual and institution and are often classed as either emotional or cognitive biases.
EMOTIONAL BIAS
Emotional biases come from instinct or intuition and tend to result from reasoning impacted by feelings.
Example: Loss Aversion Bias
Investors tend to feel the agony of losses more than the pleasure of wins compared with other client categories. Thus, these investors may hold on to failing investments too long, even when they see little hope of a recovery.
COGNITIVE BIAS
Cognitive biases come from basic statistical, information-processing, or memory problems; cognitive errors often result from erroneous reasoning.
Example: Hindsight Bias
Some investors may be prone to hindsight bias, which happens when an investor interprets prior investment outcomes as if they had been predicted. Investment outcomes are rarely, if ever, predicted.
An example of hindsight bias is the response by investors to the financial crisis of 2008. Initially, many saw the housing market’s performance from 2003 to 2007 as ‘normal’ (i.e., not suggestive of a bubble). It was only later that many said, ‘was it not obvious?’ when the market experienced a catastrophe in 2008. Hindsight bias offers investors a false sense of security when making investing decisions, emboldening them to assume excessive risk without perceiving it as such.
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