If you own a house or an apartment, you’re invested in property. If you own a silver necklace, you own precious metals. And if you’ve ever rejoiced at a favourable exchange rate when travelling abroad, you engaged in small-scale currency trading.
To some people, these things may not qualify as “investing”. But the fact is, many of the friends, family and clients I speak to are making some kind of investment decision even if they don't take place on a stock market. Bottom line: you’re never not investing.
Those who avoid shares and bonds often do so out of fear of losing money. Headlines about countries that can't service their debts or companies whose shares collapse after a scandal seem to confirm this fear. But if you understand that investing (in the broadest sense) isn’t such a foreign concept, you can start thinking about what risks you've been taking all along and, as a result, how best to preserve or increase the value of your savings to achieve financial goals.
Money in the bank: A risky investment
A current account at a bank or building society appears to many to be the safest place to store money. For funds you want access to in the short term, this is not wrong. But there are two main risks lurking: inflation and the danger of not having enough to meet your long-term financial goals.
It’s difficult nowadays to find a current account that pays any interest on deposits at all. Does this lack of return at least come with a lack of risk? Unfortunately not, because inflation makes goods and services more expensive all the time, so your money loses its purchasing power.
For years, the value of cash after inflation has been falling
How £10,000 in cash savings might have evolved, before and after the effects of inflation
Past performance is not a reliable indicator of future returns. Cash returns illustrated by ICE Libor 3-month sterling rate; inflation by the UK Retail Prices Index. Source: FactSet as at 30 November 2021.
An inflation rate of 2% effectively means £1,000 will be worth only £820 after ten years in terms of what it can buy you, £672 pounds after 20 years and £552 after 30 years. Seen in this light, a bank current account is not a risk-free investment, because negative real returns are virtually guaranteed.
If you’re putting money aside for retirement or any other goal that is years or decades away, you should try to compensate for inflation. And since a long retirement of several decades becomes increasingly likely as life expectancy rises, even preserving the value of savings is often not enough to enable a comfortable life in your golden years.
Home ownership: Danger of cluster risks
Almost two out of three households in England own their own homes1. The decision to buy one is usually not purely financial but rather has a lot to do with a desired lifestyle. But it inevitably has a major impact on wealth building.
As an investment, property is extremely illiquid. Assets are tied up in it for the long term. Market fluctuations also affect houses and apartments: The proceeds from the sale of a property depend to a large extent on the current level of demand.
Nonetheless, home ownership can also help you build wealth. Many people find it easier to pay off a home loan than to put money aside each month and not touch it again until much later. An illiquid, inflexible investment is what makes some of us disciplined investors in the first place.
The crux of the matter is the importance that home ownership has for many households’ financial planning. For most people, housing costs can represent their largest regular expenditure. If they also own their own home rather than rent, it can also represent their biggest investment.
In the investment world, that is called a cluster risk – a term you should become familiar with even if you don't have an investment account. Essentially, it describes why you don’t usually want to put all your eggs in one basket.
How to make a balanced financial plan
One important goal of a long-term, balanced financial plan is that no event should have catastrophic consequences for the plan as a whole. The components should complement each other in such a way that good results in one area can cushion possible losses in another. This applies as much to your life outside of the markets as it does to an investment portfolio.
You may have wondered in the past: what happens if inflation rises significantly? If the home loses value? If the state pension level changes? If you need money in the short term, for example to bridge a loss of income?
All of these cases would be a burden but, at best, none of them should throw you completely off track. Owning a home can help build wealth in the long term, but it's no good for covering a short-term need for money. A bank account is good for that, but it usually doesn't go far enough in closing the pension gap. An investment in the stock market with funds and ETFs can fluctuate in value but can also potentially provide the necessary above-inflation return needed to achieve some of your financial goals such as a more comfortable retirement.
This goes to show that there’s no single instrument that can carry you to all your financial goals or protect against all risks you might encounter along the way. That’s because risks exist not only in the stock market but in all forms of saving and financial planning.
The thought is uncomfortable at first. But knowing this makes it possible to build safety nets as well as opportunities for returns into your plans by combining various investments and saving instruments. The result could be a financial plan that is flexible, offers protection against nasty surprises, and just might provide more security than you think you have now.
In the next part of our four-part series, read about how to set clear and achievable financial goals.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
This article is designed for use by, and is directed only at persons resident in the UK.
The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
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