Whenever money is involved there will always be risks; some of them are unavoidable but others, with a bit prudence, can and should be avoided.
Unavoidable But Manageable Risk
Stock markets are inherently risky, they are prone to episodes of volatility and crashes. This market-wide risk is known as a systematic risk which means that the value of any single share can fall in value when the rest of the stock market is doing so too.
Think back to the Great Financial Crash (Credit Crunch) of 2008/09 when the world stock markets halved in value over the space of a few months. Investors around the world took flight as the banking crises spread to a sovereign debt crisis (or more simply, the fear of countries like Greece, Portugal, Ireland & Italy going bankrupt).
However, if you want to have longer-term returns stock market risk is a necessary evil that can be overcome with patience, diligence and an understanding of investing principles (click here for a video series about understanding investing).
For any money that you can’t or aren’t willing to expose to the vagaries of the stock market, the most secure place is a major bank or building society. For a known level of interest, you can expect to return to the bank at any point in the future safe in the knowledge that your money is available to you.
Except when your money isn’t available, which is what many savers found in 2007 with the collapse of Northern Rock and then in 2008/09 when the Icelandic banks collapsed and other large global ones had to be bailed out.
This is what is known as institutional risk and can be managed by spreading savings between a number of banks so that balances are kept within the FSCS compensation limits. It is also managed by understanding and accepting the unbreakable risk/reward relationship. In other words, if an Icelandic Bank is offering 7% for a ‘no-risk’ savings account it is probably too good to be true (which turned out to be the case!).
Long-term savers who shy away from the unpredictability of the stock markets for the security of savings are replacing the systematic, investment risk with another form of risk, inflation risk.
An element of inflation is good because it keeps economies growing but, as is often the case, when interest rates offered for savings are lower than annual inflation, the real return on savings is negative. In other words, inflation is eroding the purchasing power of your capital despite the balance remaining the same.
To give you an example, if I put £10,000 in the bank 10 years ago within an interest rate of 1% pa and didn’t touch it, the balance in real terms now would be £8,750*. You could, of course, move your money around and spread it between different term accounts to make sure you are maximising interest rates available. Most people, however, don’t and simply leave their money languishing in old accounts paying a derisory rate of interest.
If you have been on holiday since the Brexit crisis or have a business that buys good and services abroad you will be aware of exchange rate or currency risk. This is the effect that changes in the value of Sterling relative to other currencies has on purchasing power. It also applies to any overseas investments we have, particularly when we want to bring the money back to the UK.
Exchange rates can either work for or against us. If the value of Sterling falls (as it has since the 2016 Brexit referendum) the cost of buying goods and services abroad increases. Conversely, when Sterling rises in value, we can buy more foreign goods and services with our money.
We have no control over the future direction of stock markets, inflation, exchange rates or savings rates but by accepting them as inevitable and necessary factors we can mitigate the effects they have on our money. This might mean having an emergency fund in savings and committing our long-term money to the stock markets.
There are, however, risks that are entirely avoidable and that provide little upside…
If a systematic risk is a broad risk that comes with stock market investing, unsystematic risk is the idiosyncratic risk that comes with investing in a single company; RBS BP, Tesco or Carillion for example. There are company-specific risks that may not be expected but that can lead to a complete and permanent loss on an investment.
There is rarely little advantage to be gained by having an investment portfolio containing only a small number of shares. Diversifying the risk away by investing broadly within and across global stock markets can also lead to greater returns.
Other avoidable risks are any in which the risk of capital loss far outweighs the potential return. It would include, but not be limited to, investing in a property that becomes a money pit into which you end up throwing good money after bad or an investment which sounded too good to be true and was (7% pa risk-free growth anyone?).
Gambling is another avoidable risk which usually, over time, does not provide a positive return. I enjoy the occasional bet on the Premier League or the Grand National and, from time to time, my punts have come off but, like the vast majority of punters, I’ve lost more money than I have won.
And then there are the sharks. The scammers who try to con you out of your money. This can be through sophisticated investment ‘opportunities’ that offer a guaranteed rate of return to email solicitations or phishing campaigns that target the naive or ignorant. The mantra to repeat here is that if anything seems too good to be true then it is.
*Source: Bank of England Inflation Calculator using inflation data from 2008 to 2018