How Much Risk Are You Willing To Take?
What seems riskier to you? Having all your money in shares or having all your money in the bank?
Depending on your definition of risk and your goals, you could either say it is the shares that are riskier or you could say that the cash in the bank is riskier.
People often equate volatility with risk. They think that because they can see the value of their shares changing on a daily basis, that shares must be risky. It is true that if you have a very short investing timeframe, say you have a deposit for a house that you want to buy in the next year, investing in shares is risky as you are unsure what the price will be in one year’s time. It could be 20% more than you started with, but it could also be 20% less. In this circumstance you would be best off leaving your money in cash where you know what the value will be in a year’s time.
However, as your timeframe increases there is another risk that comes into play, inflation. Inflation is the silent risk in investing, constantly wearing away at your purchasing power. Currently you can get 4% on most term deposits which was unthinkable a year ago (James and I were cheering if we could get 1%). However, inflation is running at 7% per annum. So, you are losing to inflation by 3% a year. You might think “3% a year, that isn’t so bad right?”, wrong. Let me show you what happens over 10 years.
Let’s say you started the 10 years with $1,000,000.00 in term deposits. You get 4% and reinvest all proceeds, so your money compounds at 4% for 10 years. You end the 10 years with $1,480,244.00 48% more than you started with.
At the start of that 10 years, $100.00 at the supermarket is obviously worth $100.00 of goods. After 10 years of 7% inflation however that basket of goods that cost you $100.00 now costs you $197.00. This is 97% more than at the start of the 10 years.
Do you see the problem here? You have to buy $197 worth of goods with money that is worth roughly half of what it was a decade ago.
Let’s compare this with the long term market average of the Australian share market which has returned an average of 9.8% over the last 30 years. If you invested that same $1,000,000.00 at 9.8% per annum for 10 years you would have $2,653,873. This is 265% more than you started with.
Investing is how you keep up with the silent risk of inflation. You must choose the risk you want to take, volatility or permanent loss of purchasing power.
