One of the greatest challenges for investors is finding investments that have a level of risk they are comfortable with. Given the choice most people seem to prefer the return OF their capital, rather than a return ON their capital. One could say they want “no risk” investments, and this presents a dilemma because there is really no such thing as a no-risk investment.
Investors expectations are often unrealistic, either because of poor advice or a lack of understanding about how the different investments sectors operate. Any particular investment has the potential to make a gain, or to make a loss - every single investment carries a risk.
The general investment classes are cash, fixed interest, property and equities. Cash is technically any short term investment (say 1-9 months) which is liquid, or immediately accessible. You can get your hands on it when you need it. Short Term deposits, call accounts and cash management trusts are prime examples of “Cash”. They are very low risk and consequently have the lowest level of return (or interest) as a rule. On occasions though cash does perform better than other investment classes in that at least the returns don’t go negative. So nothing lost people say.
Yet they often don’t realise that there may be a loss occurring. Apart from the “opportunity cost” of holding money in cash (ie being able to invest it elsewhere for a higher return) or the institution risk that may apply (will the institution still have your money when you want it back), inflation can erode the buying power of the cash. Inflation is a killer of cash value.
If an investor was receiving a 2.0% return (after tax) on their savings account, and inflation was 3.0% per year, the actual buying power of the cash is less in 12 months time. The interest received merely helped offset the effect of inflation. The opportunity cost is of course impossible to accurately predict, but you know you need more money to buy a loaf of bread than you did a year ago, so your cash is worth less. It has lost value.
Another area of “safe” investing that frequently disappoints investors with its returns is Fixed Interest. This is the typical safe-haven investment class for retired folk or people who consider themselves to be “low risk” investors. Fixed Interest investments, as the name suggests, are cash funds put on deposit with an institution for a period of time, providing a fixed rate of return or interest. It usually refers to deposits or securities with more than 12 months to maturity. Like Cash, there is inflation risk and opportunity risk. Depending on the institution you are lending the money to (and how long for), there is also a credit risk – will they be able to pay it back?
What happens if an investor changes their mind during the term of a fixed interest investment? Say you have a 10 year bond that still has 5 years to go until the principal has to be repaid to you, but you need the money now. The institution, be it a company, local authority or the government, doesn’t have to return the capital to you until maturity – they just have to keep paying you the interest along the way. The solution is simple – you sell the investment.
And that is when losses become possible, and may be realized. Interest rates change every day, and are a reflection of the markets view on investment, government and economic risks at that point in time. If your fixed interest, or bond, investment is paying you a 6% pa interest rate but everyone else in the market can now get 8% return for the same term, why would they want to buy your lower performing investment? Rational investors don’t want to buy it - unless you reduce the price so that it is giving a 8% return. To get your bond to that rate of return you have to discount the capital value, which results in a “capital loss”.
So when you want the money mid-term on your bond, a capital loss is possible. Of course rates may move the other way and you achieve a capital gain - or increase in the value of the investment. Either way the face value, or initial amount invested, is still generating that 10% return, but the market value of the capital can change daily. And they do change daily. Unfortunately many people do not realise this until they wish to exit their investment mid-term.
Even the “safe” investments have risks. So unfortunately there is no “No Risk Investing”.
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