The consequences of taking too much risk are often in the media spotlight, but taking too little risk can also be damaging longer term. In a world of low interest rates and burgeoning inflation, investing too conservatively in assets like term deposits and government bonds can create less immediate but still material risks further down the line.
Playing it safe can be a silent killer
We are reminded of the dangers of taking too much risk in the press every day. It could be a story of a bank using too much leverage and getting wiped out, or a pharmaceutical company halving in value after a major drug trial failure.
On the other hand, we rarely receive warnings about the dangers of playing it safe. We are unlikely to read a news headline that says, “Conservative approach to drug development sees global pharmaceutical company fade into obscurity”. Yet by taking no risk on drug development, the company will gradually fail as its patents expire and competition erodes its business.
The dangers of playing it safe aren’t sudden or dramatic. They play out slowly over time and are difficult to pinpoint. They may not be newsworthy, but this can make them more dangerous. Because you only notice the effects much later, and when the problem is large and too late to avoid.
Hidden risks in previously safe investments
There are parallels in the world of investing. Playing it too conservatively may create real risks to your wealth many years down the track.
Investments like government bonds and term deposits are often viewed as a low-risk way to save and provide an income in retirement. But with interest rates at rock bottom, they are no longer a great way to create a retirement income. They are also much riskier than most people appreciate.
Inflation has recently picked up around the globe, with inflation recently hitting 5% in the United States. While we believe this is likely to be a temporary spike, even a 2.5% inflation rate would be a destructive headwind for savers. An investor paying 28% tax and investing in government bonds yielding 1.8%, would not be earning any income in inflation adjusted terms. In fact, they would be losing over 1% per annum after inflation. Investing in term deposits is even more damaging.
With interest rates near rock bottom, there is also the risk that rates rise with higher inflation expectations. This could cause the value of longer-dated government bonds to fall materially. Something we haven’t seen for a very long time.
A risk for conservative funds
All of this can create a problem for investors in some conservative KiwiSaver funds – that tend to invest largely in assets like bonds and cash.
While there are levers to partly mitigate these risks - like investing in shorter term corporate bonds (with higher yields and less interest rate sensitivity) - the risks remain. Low rates and inflationary risks create an investment problem that defines our era.
Another definition of risk
Volatility and day-to-day fluctuations in the value of your KiwiSaver account are one definition of risk. A better definition, in my opinion, is the risk of running out of money in retirement. This is a real risk in a world where investment returns are expected to be lower and people are living longer.
The recent government decision to replace conservative funds with balanced funds in their default KiwiSaver reshuffle was a reflection of this risk. The government did not think conservative funds were doing enough heavy lifting for people saving for retirement.
Who should be in a conservative fund?
In my opinion not many people should be in a conservative fund. Even those already in retirement are likely to be better served by a balanced fund.
For a couple entering retirement today, there is a 50%+ chance that one of them will live into their 90s. That is amazing news for all of us! But you are going to want to make sure your money stretches far enough. Your retirement savings pot will need to provide a regular income, while also outrunning the effects of tax and inflation. For most of us this will only be possible with investments that grow in value - like shares and property. A balanced fund is much better in this regard.
All that said, if you are further through your retirement years, or looking to use your KiwiSaver to buy a home in the next few years, then a conservative fund may still be appropriate.
Make an active decision about what is best for you
Investors increasingly need to balance the risk of short-term market volatility with the biggest risk of all - running out of money in retirement.
If you are in a conservative fund, it may be time to give us a call. The same goes if you are under 55 and in a balanced fund. You are potentially not taking enough risk - which can be a dangerous thing.