Investors’ needs, expectations and investment goals are closely linked to each other. When creating portfolios investors first think about the needs they have in terms of capital preservation, capital growth and/or income. After that they would formulate their investment goals which are reflected in their return expectations.
For the purpose of this study, investors’ needs, expectations and goals are referred to as the income or distributions investors derive from their investment. The need for income on a regular basis primarily depends on the investor’s current position in the investor life cycle and current monthly income, such as a salary or a pension that are needed to maintain a certain standard of living.
The investor life cycle is divided into three major phases in which investors have different needs, expectations and investment goals. In the first phase, the accumulation phase, investors’ main goal is to accumulate capital for immediate and long-term needs, such as a down payment on a house, children’s university education or retirement. Investors in the accumulation phase are generally in their twenties and late thirties. Due to their age and future earning abilities investors in that phase have a long-term investment horizon, which allows them to make riskier investments (Venter 2010:17-19).
The investment goal of investors in the accumulation phase can be described as capital appreciation. This is a fairly aggressive approach that aims at gaining income and not only maintaining the current level of income. In order to achieve capital gains, investors have to invest in securities that provide returns above the average nominal returns and inflation. Thus, their portfolios are usually heavily exposed to
132 equities with a long-term investment objective that allows them to deal with minor setbacks and short-term bear markets (Marx et al. 2006:245).
The accumulation phase is followed by the consolidation phase. Investors in this phase still have a relatively long investment horizon of twenty to thirty years, but have paid off much or all of their outstanding debts, and are past their career’s midpoint. Their main need is not the accumulation of more capital, as their current income usually exceeds their current expenses. They are predominantly concerned with planning for retirement and preserving capital. Due to their medium-term investment horizon investors in the consolidation phase generally prefer investments that are less risky compared to investments in the accumulation phase (Venter 2010:17-19).
Investors in the consolidation phase generally pursue an investment strategy that is known as capital preservation, as their main goal is to plan for retirement and maintain the capital wealth they obtained during the accumulation phase. Consequently investors will reduce the weight of risky assets used in their portfolios in the accumulation phase and invest in asset classes with medium risks (Marx et al. 2006:245).
This usually leads investors to trade down on equities and invest more in fixed income generating securities, such as bonds and money market instruments. Nevertheless, investors do not give up gaining capital completely, as surplus income is reinvested (du Toit 2010:50-52).
The third and final phase of the investor life cycle is referred to as the spending or gifting phase and usually starts when the investor retires. Investors’ living expenses should be covered by funds obtained during the accumulation and consolidation phase and investors generally seek capital protection. In order to avoid a decline in their living standard caused by inflation, investors’ portfolios still contain investments that are risky, such as equities, but to a lesser extent than in portfolios set up in the previous two phases (Venter 2010:17-19).
As the main investment goal of retired investors is to protect their accumulated capital, they follow a current income strategy. In current income strategies investors
133 generally use very few risky investments, such as equities, and prefer investments in fixed income generating securities, such as high coupon bonds and money market instruments. Investors with a current income strategy generally no longer aim at capital gains, but are still invested in equities in order to get returns above or equal to inflation (Marx et al. 2006:245).
The investor life cycle predominantly reflects needs of private investors, whereas the strategies, such as current income, capital appreciation and preservation are also applicable to institutional investors. Institutional investors often manage funds on behalf of clients that have different income needs and return expectations. Therefore, institutional investors need to create portfolios with different return goals and risk profiles.
In general, institutional investors do not have a finite investment time horizon as they assume that their operations will run infinitely. Thus, institutional investors generally tend to use riskier asset classes in their portfolios as they want to achieve high short- term returns and above-average long-term returns.
Financial institutions often create portfolios with certain themes or strategies that exclude the use of different asset classes. Their investment needs are therefore different, as they do not have all asset classes available from which to derive the expected returns.
According to HSBC-Trinkhaus (2010), investors’ needs and investment goals are primarily reflected by their expected returns. In order to meet expected returns, investors have to choose the appropriate asset classes and determine how much of their money they are going to invest in them. A basic rule is that the higher the potential returns of assets are, the higher the risk associated with them. Thus, the higher the income needs investors have to derive from their investment, the more risky asset classes and securities they have to use.
To calculate expected returns investors can use the total return equation as it makes provision for income and capital gains (Brigham & Ehrhardt 2005:226, 262).
134 Although they generally serve different purposes in each phase, derivative instruments can play a role in all three phases of the investor life cycle. Investors in the accumulation phase generally prefer more risky investments as they want to accumulate as much capital as possible and increase their monetary wealth. Investors therefore follow a capital appreciation strategy and would predominantly use derivative products for speculating rather than hedging. Although this strategy is very risky, investors can realise considerable profits due to the leverage and flexibility derivatives offer (Lundell 2007).
Investors in the consolidation phase generally prefer less risky asset classes and securities. As derivatives are considered risky, investors with a capital preservation strategy would typically use them less frequently or seldom for speculation but rather for hedging.
Investors in the spending phase do generally not have a need to use derivatives for speculation as they should have obtained enough funds to cover their living expenses. In order to protect their capital, investors in the spending phase can use derivatives for hedging, but as they generally prefer less risky assets and securities they generally do not use them at all. This might be a bit different in South Africa as only about ten percent of the population will be able to retire and maintain their living standards with the funds they are currently saving and investing (Jooste 2010:59).
Furthermore, investors with high return expectations and a short investment horizon are generally more interested in derivative instruments than investors with long-term investment objectives. As illustrated in Chapter Two, Sections 2.3.1 and 2.3.3, derivatives offer the potential for high returns in a short period of time due to their leverage effect.
In addition, investors, regardless in which phase of the life cycle, can use derivative instruments for hedging purposes, thus avoiding major declines in returns due to unfavourable market developments. The process of hedging with futures contracts and options was illustrated in more detail in Chapter Two, Sections 2.3.2 and 2.3.4, respectively.
135 Nevertheless, investors should be careful when using derivative instruments in order to satisfy their return expectations and meet their investment goals as these products bear risks. Derivative instruments can, as described in more detail in Chapter Three, Section 3.2 cause major losses and bankruptcy if they are misused.
Independent studies conducted by Chen (2008) and Cummins, Phillips and Smith (1998) show that institutional investors, who cannot afford or who are not willing to lose returns, prefer to use derivative instruments to hedge their long positions in their portfolios. Although they would suffer a decline in returns, it would not lead to major capital depreciations due to their hedging strategy, as return losses in the underlying long positions would be off-set by the hedging strategy’s positive returns. The benefit of the hedging strategy is that investors avoid major return declines which could cost them a lot of money.
Private investors can also make use of derivative instruments to protect their portfolios of potential declines in returns which in effect would reduce their incomes and living standards. Considering the independent studies of Chen (2008) and Cummins et al. (1998), the different phases of the investor life cycle, and the different investment strategies to achieve the investors’ goals the following two propositions can be phrased:
P1: Investors with clearly defined investment goals and return expectations are more likely to use derivative instruments.
P2: Investors with high return expectations are more likely to use derivative instruments.
After discussing how investors’ needs, expectations and investment goals affect their decisions whether or not to use derivative instruments in their portfolios, the following section will focus on how investors’ knowledge of and familiarity with asset classes and securities might affect the decision-making process.
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4.2.2 The investor’s knowledge of and familiarity with financial markets and