Retirement Life
11 July 2022

Understanding investment risk

Whatever we do in life, we take risks. Even ordinary, everyday activities such as hanging out the washing, driving to work, playing sport, or crossing the road have elements of risk that, if you took the statistics too seriously, would have us all curled up in bed all day. Fortunately, most of us can see that the rewards of enjoying a full and active life outweigh the risks involved, providing we are sensible and don’t either unwittingly or knowingly expose ourselves to too much risk. The same principles apply to managing money. It is possible to be rewarded with a good rate of return on your investments, providing you understand and manage risk.

 

Fixed interest investments such as bank term deposits and bonds offer a flow of income and an expectation that, at the end of the investment period, the investment capital will be returned intact. While fixed interest investments are considered to be relatively safe, they still carry risk, as we have seen through the Global Financial Crisis with the failure of finance companies, structured credit products and some overseas banks. Interest rates fluctuate, and setting up all your fixed interest investments so that they mature at the same time carries the risk that all your funds will be reinvested at a time when interest rates are low. Some basic principles to follow when setting up fixed interest investments are:

 

  • Ask for the credit rating of the company, bank or specific investment in which you are placing funds
  • Spread your money among several different companies or banks
  • Spread the maturities of your investments so that you are not reinvesting all funds at the same time.

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The downside of fixed interest investments is that the rate of return is low and taxable, and the tax paid return will struggle to keep ahead of inflation in the long term. An investor with $100,000 in bank deposits, who uses the interest to supplement income, could lose around 18 percent of their capital over the next ten years just by leaving it in the bank. Let me explain why.

 

If we assume a long-term annual rate of inflation of 2 percent (the Reserve Bank’s target rate of inflation), $100,000 invested in a bank deposit today will only buy the equivalent of around $81,700 worth of goods in ten years’ time. That is a loss of around $18,300 over the ten years. Not only that, the income from the investment will fall in value. If, for example, interest rates are 6 percent on average over the next ten years, the income from $100,000 would be $4950 per annum after deducting tax at 17.5 percent. In ten years’ time, however, that income would only buy around $4,044 worth of goods in today’s dollars. A retired investor who invests for income and uses all that income every year will therefore suffer a significant loss of both capital and income over the long term. Given that many people spend twenty or even thirty years in retirement, the potential loss of capital and income is huge.

Liz Koh - Financial planner, specializing in retirement planning.

Liz Koh - Financial planner, specializing in retirement planning.

The risks of investing in shares are slightly different than for fixed interest investments. The risk of loss of capital is dependent not only on the performance of the companies in which you invest but on the cyclical movements in the share market and the length of time the funds are invested for. When investing in a share portfolio:

 

  • Diversify your portfolio by geographic area, type of industry, and size of company
  • Be prepared to leave your funds invested for as long as it takes to ride through market fluctuations, which could be ten years or longer
  • Don’t panic when the market falls – falling markets are always followed by rising markets, and the best time to buy is when prices are down.

 

If your share portfolio is sufficiently diversified, your investment risk, in effect, becomes a time risk rather than a risk of loss of capital. That is to say, if the share market falls significantly, you face the risk that you may have to remain invested for a longer period than intended in order to recover value. The longer your investment time frame, the smaller this risk becomes.

 

Many investors, particularly those who are retired or close to retirement, make the mistake of misunderstanding what their investment time frame is. Your investment time frame does not end at the point when you start using the income from your investments; it ends when you need to withdraw your investment capital to spend. Investment capital is gradually withdrawn between retirement and the end of life, which could be a period of thirty years.

 

The biggest financial risk for retired investors is running out of money before they run out of life! To lessen this risk, make sure you put away enough money for your retirement and that you have some of your money invested in assets that will grow rather than be eaten away by tax and inflation – the two biggest enemies of investors.

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Written by:

Liz Koh

Liz Koh is a money expert who specialises in retirement planning. The advice given here is general and does not constitute specific advice to any person.

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