ETF Investment Strategy for Moderate Risk Investors

Introduction to Investment and ETFs

Investments are the assets or items purchased with the anticipation of generating income in the future. In the economic sense, investments refer to goods and services purchased — and not consumed today — for the purpose of creating wealth in the future. Attending university or building a factory to produce goods and services are common examples of investment. Within a financial environment, investors purchase assets with the hope that those assets will appreciate over time, thereby creating wealth. Examples of financial investment include purchasing stocks or real estate property with the anticipation that their value will rise. Despite the benefits that can be derived from investing, investment is not something an individual can take lightly. Investors must implement careful planning to reap the benefits of an investment portfolio; an investor can lose his or her funds if diligent planning is not applied (Costa, 2011).

The risks involved in traditional investing portfolios are leading an increasing number of investors to divert their holdings toward Exchange Traded Funds (ETFs) as a way to guard against those risks.

The objective of this paper is to analyze different types of financial instruments available for a moderate investor. It provides an individual analysis to determine the best investment option for a moderate investor, with a focus on ETFs and portfolio fund construction.

Situation Analysis and Risk Profile

All investments with high or moderate returns carry correspondingly high or moderate risks. Investments with no risk typically deliver low returns. In the financial world, investment portfolios such as stocks, bonds, and commodities fluctuate in value, and investors who cannot tolerate such fluctuations may find traditional stock markets unsuitable. Even placing money in a savings account carries some risk. For example, an investor depositing $10,000 in a savings account might lose purchasing power if the value of the U.S. dollar falls in subsequent years. Evaluating the risk profile of a prospective investor is therefore critical before embarking on any investment program.

Our investor is a moderate investor who intends to invest in portfolios that carry moderate risk and deliver moderate returns. Costa (2011) argues that no low-risk investment carries high returns. High-return investments carry high risks, and by the same logic, moderate-risk investments involve moderate potential losses, while low-return investments involve low risks. Choosing the best investment portfolio for this client therefore requires a thorough analysis of his investment profile across four dimensions: character, lifestyle, time horizon, and objectives.

Character

A brief interview with our prospective investor reveals that he is a moderate investor who wishes to participate in markets offering moderate returns and moderate risks. He notes that he always invests in moderate-risk instruments because of the longstanding belief that history repeats itself. Investors who seek high returns for low-risk investments tend to lose their money. For instance, many investors lost funds in the Madoff investment scheme, which advertised low risk and high returns. Furthermore, many companies collapsed in 2008 following the U.S. economic crisis, partly because financial institutions had committed to high-risk portfolios such as hedge funds, ultimately going bankrupt. Our client's disposition cannot support high-risk portfolios. Equally, he is not interested in low-risk, low-return instruments. This paper therefore recommends a moderate-return investment strategy.

Lifestyle

Our client lives from his earnings and sets aside savings for future investment. He is looking for investments that allow him to live comfortably while maintaining a balance in his savings account.

Time Horizon

A moderate investor generally wishes to invest for at least three years before accessing investment returns. Importantly, such an investor must be able to manage the emotions that arise from return fluctuations over that period. It is anticipated that returns may fluctuate within the first year of investment. Our client is prepared to leave his portfolio intact for three years before seeking returns, and he expressed a preference for medium-term investments. Many experienced investors recommend a medium-term horizon of between three and five years.

Objectives

Our client's objective is to invest his funds in portfolios that generate a stream of income. This objective makes it critical to diversify his holdings in order to reduce volatility and risk. Accordingly, his investment plan calls for allocation across multiple asset classes, including shares, bonds, stocks, and money market instruments.