Most investors have the wrong end of the stick when it comes to risk. The general rule is that in a standard portfolio, stocks and shares are the highest risk, and cash is the lowest risk. It’s another one of those common lines that has been around so long, and is such a well known part of ‘investor education’ that no one is prepared to stand up and say anything different.
Except us, of course.
The truth is, this accepted pyramid of risk is all wrong. In reality, when it comes to growing your wealth over the long term, holding cash is the biggest risk to reaching your objectives and funding the lifestyle that you want.
Right, let’s dive straight into it. Risk is the potential to lose money. Betting on a horse is very high risk, because you could easily lose money if it doesn’t win. Putting money into a business is high risk, because it could fail and close down. Investing into a new crypto project is high risk, because it could be a complete scam.
Even investing in big, mature companies can be risky. Blockbuster went bust. So did Toys R Us, Thomas Cook and Debenhams. If you’d tried to stock pick your investments and you ended up with a few of those in your pot, you probably wouldn’t be too happy.
Now cash doesn’t do big dramatic falls like that. You won’t ever put £50,000 in the bank and then open the app a week later to see it at £30,000. Apart from a little bit of interest, that £50,000 will stay at £50,000 forever. And that’s the problem.
That £50,000 will remain at £50,000 while the prices to buy everything go up all around it. The rate at which prices go up is called inflation. It’s a hot topic right now, but it happens every year. Generally, inflation runs at around 2-3%, which means that the average price for everything we spend our money on goes up by 2-3% a year.
This is important because our wealth only increases if we can buy more of something or higher quality versions of it. We want to grow wealth so that we can buy a bigger house, a nicer car, a better holiday. If our net worth isn’t rising faster than the rate the cost of those things is going up, we’re not getting wealthier even if our bank balance is growing.
It’s a weird concept to get your head around, so let’s look at an example. Say you have £100,000, and the price of a new Apple Macbook is £1,000. With your £100,000 you could buy 100 Macbooks. Not bad.
Now say the price of a Macbook goes up by 3% next year. They now cost £1,030. You still have £100,000, but now you can only buy 97 Macbooks. Your net worth is the same on paper, but you’re actually three Macbooks poorer than you were last year.
This process works the same for bottles of wine, for holidays, cars, fuel, childcare, energy bills and trainers. The costs for everything go up all the time, and if your money isn’t growing with it, you’re able to buy less each year.
So going back to the definition of risk, it’s the potential to lose money. Cash doesn’t just have the potential to lose money. In tangible, usable terms, it’s guaranteed to lose you money every single year.
But hold on a minute, what about those examples of companies that went bust? How can we say that cash is riskier than that? It’s true, if you invest into a single company, there’s a risk you could lose some or all of your money. This is called single company risk.
Practically, there’s a couple of reasons why it's not the same. Firstly, any investment has the potential to make you money. The higher the potential return, the higher the chance it doesn’t work out, but as long as you know the risks going in, you still might want to take the chance. Cash doesn’t have that potential to grow. The cash value will always be the same. Even if you get some interest in a bank account, it’s rare for this to be above the rate of inflation.
Secondly, there’s a magic trick you can pull with investments that makes the chance of losing everything disappear. It’s called diversification. Investing into a single company, or even a handful, can end in disaster. But if you spread your investment across thousands of different companies, the chances of them all going to zero basically doesn’t exist.
It’s one of the reasons why we invest using Exchange Traded Funds (ETFs) that can cover whole stock markets in a single fund. It means there’s no betting on individual companies, just strategic moves based on how a country/region/industry’s entire stock market is likely to grow.
This doesn’t mean that the investment value can’t go down in the short term, it can. But over the long term, the risk of inflation slowly eating away at your net worth is way lower. This means that not only can you protect the money you already have, but you can grow it above the rising cost of living, to improve your lifestyle and work towards the type of retirement you want.
Please note that this is not a financial advice and it does not take into account individual circumstances. Please also contact a professional advisor prior to any decision making.
The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. You should be aware that past performance is no guarantee of future performance.