The most common method of saving for retirement is through a pension scheme. The two main types are defined benefit (final salary) and defined contribution (money purchase) pensions though only the latter is dependent upon investment returns to provide an income.

How to invest money

It is important to save tax efficiently. This will give you the highest investment returns for a given level of risk.

Although they may be the most tax efficient means of saving for retirement it is important to weigh up the benefits and drawbacks of pensions to establish whether they are the right option for you. Alternatively you may prefer to invest via tax free savings plans, investment (insurance) bonds or even in an account with no tax relief. The latter would offer complete investment freedom. For most people however, investing tax efficiently would offer an abundance of choice to meet their requirements.

Where to invest money

Investing should be tailored to an individual and, as such, there is no general investment strategy that is best suited to everyone.

The main categories of investments in order of risk (low to high) are cash, bonds, shares or stocks, property, commodities, hedge funds and alternatives. Further to this you have to decide on currency and geographical location. For the latter, developed countries (Europe & US) tend to be lower risk than developing markets (Asia ex Japan). This was generalised to highlight broad differences in the options available to you. It is quite feasible for certain bonds to be riskier than shares for example.

Investment definitions

Bonds are loans made to governments or companies. Typically they pay a fixed rate of income for a set period and at the end the initial loan is repaid.
Shares (also known as stocks) are certificates that give the holder part ownership (share) of a company. This entitles them to a split of any dividends (income) paid out and the underlying value of the firm. In the event of liquidation shareholders cannot lose more than they invested.
Investment property can be residential (private) or commercial (shops, factories etc).
Commodities are homogeneous goods we require such as metals, oil, gas, coffee etc.
Hedge funds are companies that can take “short” positions. Shorting a stock is selling a share you don’t own. They can therefore profit when markets go down as well as up.
Alternatives form a varied selection of investments which don’t fit in to the above categories. They tend to be specialised and can be high risk, high reward. It is very possible to lose well in excess of your initial capital with them.

Investment principles

There are certain key points applicable to all types of investing which you should be aware of. Being fully informed of these may prevent you from making costly mistakes;

  • Know whether you are risk averse, risk neutral or a risk taker
  • Be aware that markets have cycles
  • Taking less risk can generate higher expected returns
  • Effective diversification reduces risk
  • Risk and returns are unidirectionally linked
  • Benefit from understanding risk
  • An investment’s risk changes over time

Are you risk averse, risk neutral or a risk taker

You will fall into one of three risk categories: risk averse; risk neutral; or risk takers. Risk neutral is when you are indifferent upon how expected returns are generated. Given the choice of either receiving £5 or flipping a coin to win £10 a risk neutral person would not have a preference as, in both cases, the expected return is £5 (50% x £10 + 50% x £0 for the coin flip). A risk averse person would receive £5 whilst a risk taker would flip the coin.

If, in the above example there was only the option of a coin flip and you had to place a bet then a risk adverse person would bet up to £4.99, risk neutral £5, and a risk taker up to £9.99.

Market cycles

As the investment markets are made up of the risk averse, neutral, or takers, then prices for investments can change according to sentiment. In periods of euphoria the market will have more risk takers willing to pay ever higher amounts. The opposite is true in periods of depression resulting in lower prices even when expected returns don’t change.

How less risk can generate higher returns

By establishing which sectors of the market are out of favour it can be possible to buy at subdued prices. Buying at these times has proven to increase returns whilst the contrary is also true. Therefore, it is possible for lower risk investments to generate higher returns by buying at the correct time.

Effective diversification

Diversification is simple in theory. By holding more investments you reduce the risk that any under performers cause untold harm to your savings pot. Ultimately, a diversified portfolio will not give the same potential returns as a single investment which is also the main advantage – the extremes are taken out of the equation.

Effective diversification is establishing how different investments react in specific market conditions. Choosing a mix of those with opposing reactions (negative correlation), the same reactions (positive correlation) and unrelated reactions (uncorrelated) should allow an investment portfolio to perform well over the long run. Ideally, the result will be outperformance with reduced volatility.

Risk and returns

For long term investments you should be looking to achieve the highest expected returns for a given level of risk (specifically volatility). Therefore, if you want to get a greater potential return you will have to take more risk.

On the contrary, taking more risk does not necessarily mean you will have a higher expected return. An extreme example of this is the lottery which has a negative expected return – only part of the money received is paid out in prizes. People play because of the risk and the slim chance of a large payout.

Benefiting from understanding risk

Risk comprises of volatility and time. The latter is often forgotten about because people focus on the present. If saving for retirement in 20 years does it really matter if your investments drop 50%? Actually, sizeable drops can work in your favour. There are ways to mitigate risk including investing regularly and setting clear objectives.

How investments’ risk changes

As mentioned, risk is a combination of volatility and time. If your level of risk doesn’t change then the longer your investment horizon the more volatility you should consider taking. Combining this with the knowledge that to get higher returns you have to take greater volatility then to achieve the best retirement returns involves accepting more volatile investments at the beginning and gradually replacing these for less volatility assets towards retirement. This is also why holding cash for prolonged periods is usually a bad idea.


Costs have a large bearing on long term returns. As such, the natural response would be to invest in the lowest cost structure and investments as possible. Unfortunately this is not straight forward especially when comparing across different asset classes. Some may appear free (bank accounts) whilst others may have initial costs (property via stamp duty, legal fees etc), ongoing costs (mutual funds) or both. Comparing shares vs property costs shows the latter having more ongoing costs despite initial impressions possibly being to the contrary.

One method to compare investments on cost is to look at their net returns. After all it is better to pay higher explicit costs and get a better net return than pay apparently less for a poorer return. A lot of costs may be hidden to you when investing so if something appears cheap or free ask yourself why.

Investment strategy

When investing for retirement it is important to have a strategy. This should involve creating an objective, establishing a cost, assessing your savings requirement, modify if required, invest accordingly and monitor progress.

Objective: Both husband and wife retiring at 65 in year 2033
Cost: £1,780,000 (average joint retirement fund required in 2033 based on Office of National Statistics figures)
Retiring in Europe so cost is €2.13 million based on current exchange rates
Savings requirement: Assuming current pensions are on track to be worth €1.13 million a shortfall of €1 million would require savings of between €1,481 pm (10% p.a. growth rate) and €2,599 pm (5% p.a. growth)
Modify: If saving this amount is unrealistic over the course then either retirement will have to be postponed until later or expectations for retirement income will have to be adjusted
Invest accordingly: If the maximum savings capacity of the couple is €1,500 pm for the foreseeable future they may be forced to take additional risk to reach their goal. The alternative will be going back a stage and modifying their expectations
Monitor progress: Review progress on a regular basis, at least once a year.

Investment choice

This will be down to your personal preference. As mentioned earlier, assuming your attitude to risk does not alter whilst you are investing for retirement you should be choosing higher volatility assets at the beginning and then transferring to lower volatility assets as you near retirement. There are funds (groups of investments) that do this on your behalf which are known as target date funds.

Target Date Funds

These invest in a basket of investments dependent on a target date, usually retirement. They use the principle, as mentioned earlier, that you should be taking less risk the closer you come towards your objective. As such, retirement planning for 20, 30, 40, 50 & 60 year olds will look suitably different.

A major drawback of using such funds is that they are generic. They are unlikely to match your specific risk tolerances throughout the period in question and will force you to take more or less risk when it may not be in your interests. For example, if markets fall you may wish to remain invested to await a recovery or, alternatively, if markets are riding high you may wish to lock in profits early and move to a more defensive strategy if you are nearing retirement. Also, market cycles could mean transferring into a classically lower risk investment (bonds instead of stocks) at the wrong time which may instead increase risk. You may therefore prefer to set out an investment strategy yourself or with the help of professional advice.

Self investing

Specific investment options will be down to the level of risk you are willing to accept. Self investing will provide a tailored investment solution to your specific requirements. This takes more time and dedication though the upshot is greater control over your wealth with the potential benefits that brings.

How much risk to take

The level of risk taken is down to you, though, at the earlier stages of saving for retirement, it is not uncommon for people to invest in higher risk options. These may include investing in individual companies, small companies, emerging markets or commodities. There are huge variations in each sector from both a potential risk and return prospective. Before committing to a higher risk strategy ensure you are comfortable holding your investments if the market drops. This will prevent panic selling and allow you to buy in at a much lower price with any regular pension contributions. This indifference to market conditions will allow you to capitalise.

Saving at retirement and beyond

Once you have reached retirement it is unnecessary and unwise to have transferred all your wealth to cash as a way of minimising risk. This is because you can expect to live for many more years. As such, you should still be invested. The types of investments you hold will be dependent on your attitude to risk, but they should now be of a lower risk profile than when you started saving for retirement.

There are further options available upon retirement. It may lead you to continue to invest and take income payments when required. If you choose this option it is critical that you withdraw the correct rate and are aware of the potential pitfalls of doing this.