Are low risk assets as safe as they seem?
Are low risk assets as safe as they seem?
Investing your wealth involves a lot of decision making. One of the first choices you need to think about is how much risk you’re willing to take on when it comes to the asset classes you’re investing in. Traditionally some assets (like shares) are considered ‘risky’ and others, (like cash and term deposits) are considered ‘safe’. You probably won’t be surprised to hear that the reality is not so simple.
Defining the risk level that applies to your assets isn’t as simple as defining them as risky or non-risky. Asset classes and individual assets have their own pros and cons. Each one is subject to different levels of risk and market forces. It’s easy to say cash is safe, but what about inflation? Shares are considered quite risky, but within the share asset class, there’s a range of risk levels. Some blue-chip shares have very low risk, even though they are part of what’s considered a risky asset class.
A few of the risks every investor faces
Market risk is the risk your asset will lose some or all of its value due to market forces
Interest rate risk is the risk that your income producing asset could suffer a loss of income due to interest rate drops.
There’s political risk, if your asset is tied to the political wellbeing of its country of origin (almost every asset carries this risk). And there’s liquidity risk, which means you can’t sell your asset quickly to realise funds (a common risk of property).
Inflation risk and tax risk are the risk your asset’s value or income will be eroded by tax bills or the rising cost of living1.
Generally speaking, the most popular assets which are least risky overall are cash, cash equivalents, and term deposits. However, as we’ve already mentioned, none of these are free from risk2.
Risks of Term Deposits
Term deposits are considered safe investments. You’re giving your money to the bank, so there’s very little chance of losing your investment.
Term deposits still hold risks for investors. Firstly, because they are usually for a set term, any attempt by the investor to withdraw their funds early for any reason will result in early exit fees being charged. Banks offering the higher rates that fixed term deposits usually attract expect to keep your funds until the end of the term and they’ll punish you if you try to extract them early.
Depending on how long your Term Deposit is for, you might also risk interest rates rising while your funds are invested at a lower rate (which may have seemed great when you made the investment). This could work in your favour if you fix a Term Deposit at a particular rate and the interest rate moves down.
Automatic rollovers can also be a risk. If you don’t take steps to get your funds back before the end date you might find your funds have been rolled over for another term. And you can’t be certain you’ll receive the same interest rate either. Often the first rate you’re offered will be higher than the second and subsequent rates (this is called reinvestment risk).
Make sure you read your Terms and Conditions carefully before entering into the term deposit. Check the rate your funds will be reinvested at if you choose to rollover. If you don’t want your deposit to automatically roll over, make sure you’ve notified the bank by the date they specify3.
Risks of cash
A major risk of holding large amounts of cash is inflation risk. If you choose not to invest your cash into capital growth assets, it will lose value over time as inflation erodes its buying power. If you put your money into a standard bank account, or even a term deposit, you must consider the effective interest rate alongside the inflation rate.
You’ll be expected to pay tax on your income too, so you may find your earnings are reduced by income tax paid on your earnings. At worst, you could discover your fabulous term deposit with the generous interest rate is actually costing you money. Warren Buffett speaks strongly about this topic in Business Insider4.
Risks of currency
Currency risk becomes an issue for investors who hold cash or an investment in a different currency to that of the country in which they reside. As the relative value of the foreign currency rises and falls, so does the value of the investment. If you make a deposit or purchase an asset in foreign currency you take on this added risk, along with political risk and inflation risk.
Business and companies who deal with foreign currency frequently or whose business revolves around the purchase or sale of products overseas have the option to hedge their risk by buying or selling currency at a given rate, to offset the risk of the currency moving on their investment. This is effective, but is hard to do on a small scale and comes with added dealer expenses. This is more the domain of a Foreign Exchange dealer, instructed by the treasury of a company, not so much an individual investor. Individuals must acknowledge the risk, compare it to their potential returns and make their decision accordingly.
A mix of assets is the wisest investment
Even the safest assets still have risks and reasons for and against investment. We’re not suggesting you should pull all your money out of cash and term deposits. We’re just giving you another perspective, because what makes some investments seem ‘safe’ at first glance, can count against them in reality.
Cash is a classic example. Leaving funds in a bank account doesn’t risk your capital and the bank will return your cash quickly if needed. The risk is that your money may not buy as much as it used to and you’ll probably have to pay tax on what you’ve earned. A mix of asset classes with a range of different risks and returns may help your investment portfolio withstand the individual risks each asset faces.
It pays to seek advice on the mix of investments and assets classes that’s best for you and your investment needs. The wealth management team at Modoras can help ensure you have the right investments for your goals. Call them on 1300 888 803.
Over to you
Been caught out by a ‘low risk’ asset that ended up going rogue? Let us know in the comments.
- Money Crashers – Low risk investments high returns
- Country Financial – Investments: Most and least risky investments
- Canstar – Term Deposits: Five Term Deposit traps
- Business Insider – Warren Buffet, Feb 2012: The investment everyone thinks is safe is actually the riskiest in the world
This article is published by Modoras Pty Ltd ABN 86068034908 AFS and Credit License No. 233209. This article contains general information only and is not intended to represent specific personal advice (Accounting, taxation, financial or credit). No individual personal circumstances have been taken into consideration for the preparation of this material. It is recommended that you obtain your own personal professional advice before making any financial or business decision.