When it comes to savings and investments many people think that holding cash is the no risk option. However, the better investor makes a decision on which risks to take and which to avoid. Doing nothing, including staying out of the market, carries risk. With inflation running at anything between 3 per cent and 5 per cent depending upon which month and which measure you use, and returns on cash, after tax, often less than 1 per cent holding low risk/return investments actually carries two big risks.
The risks in so called ‘low risk’ investment options
Firstly, there is the potential higher return you could have earned elsewhere if you had taken more risk. Secondly, the real value of your money, measured in what it can buy in the future, has actually fallen as you are not getting a return that at least keeps up with inflation.
Another risk is that of liquidity. Many feel that holding bricks and mortar is the best investment as it always goes up. However, if you need to sell quickly you may face problems. This is especially true of many commercial property investments in the current market. Often selling early means taking less than you could have got by holding on for longer.
Price fluctuation is another risk people want to avoid. They are more concerned, that the value of their investment will be less than they paid in say one year’s time, than they would be happy if the same investment goes up in value.
As I have commented before in this blog what really matters is the length of time that you hold an investment. If you want the money back in say one or two years then you probably have little choice but to hold cash. However, if you invest in a pension with a retirement age say over 10 years away then the daily and monthly fluctuations of that investment are worth bearing for the higher return available by taking more risk.
Many people buy investments when they are high as they follow the crowd thinking they will keep on going up. When the value of the investment falls they sell and effectively end up buying when the price is high and selling when it is low, with obvious consequences.
When prices fall this means equities are cheaper than they were before and so this is the best time to buy, when everyone else is selling. The message here is buy and hold and don’t let emotion get in the way of a good investment decision.
One important principle of investment strategies, that removes some risk, is to hold assets of different types or classes. For example, a well balanced portfolio would hold a mixture of fixed interest securities and equities. These in turn would be geographically diversified as well as diversified by sector. So holding one UK property as your main investment (say the house you live in) hardly represents a well-diversified investment portfolio.
So when you are nervous about the risks you are taking just remind yourself of the risks you have avoided by taking those investment decisions in the first place.
Chartered Financial Planner and Financial Advisor, Birmingham