What risks lurk in each asset class
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Christine Benz is the director of personal finance for Morningstar US. This article was originally published on the Morningstar US website.
Academics and finance professionals sometimes refer to the "risk-free rate of return" as a benchmark. In this context, the risk-free rate is the yield on cash assets, where you're guaranteed stability of principal even as you pick up a slight (these days very slight) return.
But no investment is 100 per cent free of every possible risk. Even as assets parked in term deposits and online savings banks won't fluctuate in value, investors who park too much in them can face other types of risks, including inflation risk and shortfall risk.
Meanwhile, stocks have a much higher level of risk in the conventional sense, in that you could lose all your money and never recover it. At the same time, an investor who buys and holds a mostly stock portfolio generally faces less of a shortfall risk than the investor who parks the same amount in cash over several decades.
Because every investment entails at least some type of risk, investors would do well to make sure they understand the key risks associated with each asset class, build portfolios well diversified across asset classes (and, in turn, risk factors) and don't take more risk than they can afford, given their time horizons.
Here's an overview of some of the key risks associated with each asset class. Note that some of these risks cut across asset classes, for example, valuation or price risk is associated primarily with holding stocks but it can affect bond investors, too.
Cash and cash-like investments
Inflation risk: One of the big risks for investors in fixed-rate securities -- especially ultra-low yielding securities such as cash -- is that their investments may not earn enough to keep up with inflation. That's certainly a big risk today.
Cash yields in Australia are mostly all under 2.5 per cent but the consumer price index was running in the neighbourhood of 2.3 per cent in the third quarter of 2014. That means investors holding too much cash aren't preserving much of their purchasing power. The longer the holding period, the more inflation risk should be a concern.
Shortfall risk: Investors can fall short of their financial goals for many reasons -- key among them is saving too little. But if you're saving for a long-term goal, holding too much in investments with little to no short-term volatility but commensurately low returns can help exacerbate shortfall risk.
Longevity risk: This is the risk that you live longer than your savings can support. As life expectancy increases, it is essential to take into account the possibility of outliving your income stream. Calculating how much an individual needs to save for retirement requires weighing up factors such as savings rate, income needs in retirement and life expectancy.