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In a previous blog post we dealt with the impossibility of avoiding risk altogether when investing and the importance of working out your own personal tolerance to risk and then diversifying your assets.
In this post, I’d like to highlight the different types of risk involved in investing.
Inflation is a silent thief which can erode your savings and your investments if you are not careful. The return on your investments must at least equal the rate of inflation if they are to hold their value. If they fail to do so, over time your purchasing power will be diminished.
So let’s say you are 30 and you win the lottery today and put $1,000,000 towards your retirement. Sounds like that will be enough for you to retire on doesn’t it? But in 35 years’ time, when you retire at 65, that $1m will be worth significantly less. If we assume an inflation rate of 3%, its value will have diminished to just a little over $350,000 in today’s terms. Not quite the nest egg you might have imagined to see you through your golden years.
This is one reason why it is important to regularly review your portfolio and ensure that your returns are keeping pace with inflation.
All investments are subject to market risk no matter which asset class they belong to. This is because the market reacts to factors which are out of your control such as the economic situation of countries where you are invested, or even the global economy. You might hold shares in a company with a rock solid track record but if the stock market crashes, your investments could still suffer, investors discovered after the global financial crisis of 2007.
The markets also follow trends – gold was strong when equities suffered post-2007, peaking in August 2011, but its price has tanked recently as other asset classes have recovered and investors have adjusted their portfolios accordingly.
There is always the possibility of default risk on both equities and bonds when you invest. Default occurs when a company fails to service its debt obligations. If a company cannot pay its debts, it could end up filing for bankruptcy and shareholders could end up with shares worth nothing. As some investors learned the hard way in 2008, even seemingly-impervious giants of industry are fallible. Lehman Brothers was the fourth largest bank in the US at the time of its collapse yet its $639bn worth of assets were not enough to save it.
This is one reason why diversification is key – holding shares in a single company exposes investors to too much risk. Bonds are considered a far safer bet and defaults on high quality bonds are rare but can still happen.
Certain long-term investments such as annuities are a good safeguard against running out of money as you receive an income for life however long you live. Mortality risk is calculated by the insurance company by making assumptions about life expectancy to determine how much the annuity costs. The risk with annuities is that you die before you have received enough payments to make your initial investment worthwhile.
On the other side of the coin, not having enough saved for retirement could leave you short of money in your golden years and unable to lead the comfortable life you would like. It is a delicate balancing act and one which you can only achieve through careful financial planning as early as possible in your working life.
For help in managing the risk involved in investment and getting the best out of your savings, a good financial adviser can be invaluable.
If you want to discuss risk, investments, savings or any other financial planning issue get in touch today for a free, no obligation meeting with one of our qualified consultant.
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