Investment risk: like the toss of a coin
Investment risk can be hard to define. For most people risk is the possibility that they will lose money on their savings, but there is also the risk that your investments will not grow fast enough to meet your needs. This can be a serious problem if you are trying to build up your savings, say, to help offspring through university or for your retirement.
It doesn’t mean you should invest everything in high-risk, high-return investments such as shares. It is possible to enjoy the best of both worlds – potentially higher returns than cash deposits but without the volatility of the stock market – if you choose the right mixture of investments.
When making investment decisions, many people are torn between two emotions: greed and fear. The greed factor can overcome fear when they see others making large profits from investments such as shares or in the property market.
However, if everybody piles into these assets, there is a danger they may become overpriced, which can lead to stock market bubbles and property booms that eventually may end in sharp price falls.
All investments involve some risk. Cash deposits are at the safest end of the spectrum but interest rates will fluctuate up and down so returns are uncertain. More importantly, there is the risk that inflation will erode the purchasing power of your capital. Inflation, as measured by the Retail Price Index, has recently been running at over 4% but even if inflation were to average a modest 2.5% after 10 years, your money will buy 20% less than today.
Individual shares can be particularly risky. The price of a share can fluctuate from one day to the next depending on the flow of good or bad news about the company. Investing in a spread of shares through an investment fund will spread the risk, but your investment will still go down in value if the stock market falls generally.
Nowadays property is a popular investment and many people have bought buy-to-let properties, but property prices do not always rise. After the property boom of the late 1980s, there was a period from 1989 to 1993 when average property prices fell by 20%. It was not until early 1998 that they were back to the level they had been in 1989. For buy-to-let investors there is also the risk of void periods between tenants when there is no rental income.
Sticking to cash over the long term, though, will mean your potential returns are much lower. After inflation, Barclays Capital Equity Gilt Study shows that the ‘real’ returns from cash over the last 20 years were 3.7% per annum compared to a real return of 6.9% per annum from shares. Over the last 50 years, cash produced a real return of only 2% compared to a 7.1% real return from shares.
You can benefit from potential increases in share prices without as much risk if you invest in a wide portfolio of different types of investments – shares, commercial property, fixed interest securities and cash. These assets perform differently in different market conditions, so if one performs badly there is less chance of your whole portfolio falling in value. You could put together your own portfolio using different investment funds but managed funds or with profits funds will provide you with a one-stop shop.
They hold ready-made portfolios of these assets and are managed by professional investment managers who can alter the balance of the portfolios to take into account changing investment conditions.
With profits funds can provide the greatest smoothing effect through their bonuses which are used to distribute investment returns gradually, holding back some profits when markets are doing well and using these reserves to cushion bonus falls when markets go down. Different funds carry different levels of risk dependent upon spread of investments, therefore risk is not managed by fund entirely.
Wesleyan Medical Sickness provides specialist financial advice for dentists. For further details ring 0808 100 1884 or visit www.wesleyanmedicalsickness.co.uk.