How much risk to take? Two investors, Isabel and Alexander, respond to life changes

You may remember Isabel and Alexander from a previous article, When to accumulate and when to generate income. At that time, Isabel was in a well-paid job and preferred to invest in an accumulation fund. She aimed to maximise the long-term value of her investments while covering her day-to-day expenses with her salary. Alexander meanwhile was working part-time and caring for his elderly parents. He used an income fund to supplement his earnings.

A few things have changed since we last saw them and now both investors are in the market for a new income fund. But as their circumstances differ, so does their appetite for risk. So, which type of income fund will they choose?

The big change in Isabel’s life is that she has chosen to quit her job and pursue her dream of starting her own business. Isabel had worked as a software engineer for many years, building up a sizable “rainy day” fund. She has decided to use this fund to support her while she develops her business plan – her hope is to use her technology background to disrupt the travel industry.

 “I’ve always wanted to be an entrepreneur,” she says. “I don’t want to miss my chance to do it. I’m taking the plunge!”

After discussing her situation with a financial adviser, Isabel has decided to invest her “rainy day” money in an income fund. Her plan is that the income from the fund will help cover her living costs while she sets up her business. With the help of her adviser, and a few cutbacks on everyday expenses, she thinks she can afford to spend one to two years getting the business off the ground.

Alexander has experienced an even more significant life event: his elderly parents have died. After arranging their funeral, clearing out their apartment and taking time off work to grieve, he is now assessing his financial position. As the only child, he will inherit most of his parents’ wealth, minus inheritance tax and legal fees.

The inheritance is significant. It may be enough to buy a home outright. But Alexander isn’t yet sure where he wants to live in the coming years. One silver lining of his parents’ death is that his caring responsibilities are over, which means he has more freedom than before. He is considering taking a break from work to visit South America.

“The last few months have been tough,” he says. “Emotionally demanding. I feel I need a break and a reset. Then I can decide what to do with the rest of my life.” 

In the last few years, Alexander has become accustomed to supplementing his part-time salary with income funds. He has decided to use some of his inheritance to generate an income in the same way. He hopes the income from the fund will cover his costs while he is on his travels.

While Isabel was in full-time employment, she was able to take a long-term approach to investing. Her hope was that the money she invested each month would not be needed until she retired. That meant she was willing to take a reasonable amount of risk with that money, in the expectation that over the long term, that risk would be rewarded with a good return.

With her “rainy day” money, however, she is taking a different view. Her employment future is not secure, and she wants to ensure she does not use it up before she gets her business established.

“This cash pot could be the difference between success and failure of my business,” she says. “I have to make it last!”

Isabel has chosen an income fund with a low risk rating.¹

• Income funds of this type are more likely to invest in bonds than equities.
• They may invest in fixed income instruments, such as short-duration bonds or floating rate notes, which tend to be less volatile than other types of asset.
• Less risky funds are not likely to achieve very high returns, but they are also less likely to experience high volatility and drawdowns.

Isabel has decided this is a more suitable option for her.

Alexander, on the other hand, has decided he is willing to take more risk with his new investment. Now he has the security of his inheritance, he is confident he will be able to meet his needs in the coming years.

“My retirement isn’t too far away,” he says, “I’m hoping my investments will grow between now and then.”

Alexander is willing to explore income funds with a moderate risk level. 

• Funds of this kind may invest in assets such as equities; often, they target companies that pay high dividends. 
• They may include multi-asset funds that use diversification – for instance by investing in equities, bonds and other assets such as commodities.
• They aim to achieve a balance between risk and return.

Alexander knows his new fund may experience volatility and potentially drawdowns, but he is confident he can endure some periods of underperformance in the expectation that, over the long term, his fund has a better chance of achieving good returns. 

The difference between Isabel and Alexander is their investment horizon. Isabel’s timeline is spread over one to two years – she doesn’t want to take on the risk that market volatility could deplete the value of her funds before she gets her business off the ground. Hence her low-risk approach.

On the other hand, Alexander’s inheritance has given him more financial security. With his immediate needs met, he can afford to take a long-term perspective – thinking ahead to his retirement in 10 or 15 years’ time. That means he is comfortable taking more risk with his investments, in the hope that over the long term, that will lead to a better returns.

Are you considering investing in an income fund? Is your situation more like that of Isabel or Alexander?

¹ In Europe, for example, risk ratings are usually displayed as a summary risk indicator, which is a standardised risk measurement included in a fund’s Key Information Document. The indicator displays risk on a scale of one to seven with one being the least risky and seven being the most.