The idea of risking your hard-earned savings in the stockmarket can be nerve-wracking. It may be tempting simply to stick your money in the bank. But what you must realise is that every investing decision you take including staying out of the market altogether carries risk. The key is understanding which risks you can afford to take, and which you should avoid. Here are some of the biggest.
Opportunity cost and inflation risk
If you keep your money in low-risk, low-return assets, there are two big risks. First, you sacrifice the returns you could be making if you had invested elsewhere. Worse still, your wealth could be eaten up by inflation.
For example, if you try hard, you might get a (pre-tax) return of 2.5% on cash savings today. But prices (measured by the retail prices index) are rising at 3.1% a year. So after a year, your savings will buy you fewer goods and services. They've lost value in real' terms.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
The same is true of the tiny returns on so-called risk-free' UK government bonds (or gilts'). The government is unlikely to go bust: it will always be able to pay you back, even if it has to print the currency to do so. But with bond yields well below inflation, every day you hold gilts, you risk losing money in real terms.
Liquidity risk
Timing matters in investing. If you are close to retirement, for example, you should focus not just on the return on your money, but also the return of your money. In short, you need liquidity the ability to get out of a position quickly, at minimal risk of loss. Some assets are far more liquid than others. Big blue-chips can be bought and sold on the market easily and at low cost, even in the toughest conditions. More obscure stocks and bonds aren't as easy to offload. And buying and selling property takes weeks or months, not seconds.
So, when you look at your portfolio, ask yourself: "How easily can I get out of this asset at short notice? And how likely am I to need to do so?"
Price risk
The fact that asset prices go down as well as up is what puts many investors off the likes of equities. So they buy low-risk' investments. But this can actually be a crazy strategy if your financial goal (usually retirement) is a long way off. If you have 20 or 30 years to go, you can afford to take lots of risk early on, aiming to earn a decent return.
Also, you should positively welcome falling share prices: the further they fall, and the cheaper they get, the more you can afford to buy. It's this buying cheap assets with the potential to offer big long-term returns that is the secret to growing your retirement pot.
You can afford to tolerate a bit of price risk in the meantime. The best way to deal with it is to spread your money across different asset classes. For example, inflation is usually bad for bonds (as most pay a fixed income), but it can be good to a point for equities, as long as the firms you own can raise prices to compensate. Even humble cash accounts can do fine if the interest rate keeps pace with prices.
So, as financial planner Carl Richards notes in The New York Times: "The next time you're nervous about the risks you are taking remind yourself which risks you've actually got rid of because of those decisions."
