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Few people would relish the thought of taking risks with their retirement savings. Yet the reality is you’re exposed to a range of different risks that can affect your investment returns and how much money you end up having in your super account when you finish working.
We look at nine investment risks and the impact they can have on your super nest egg.
While investing always goes hand-in-hand with risk, the particular risks your super account is exposed to vary depending on the underlying assets. Not every investment risk applies to every asset, or all the time:
1. Market risk
This is the risk that your investment will decline in value due to economic developments or other events affecting the entire investment market. Market risk covers things like:
- Changes in domestic and international economic conditions (like a recession or boom)
- Government policy changes (a decision to impose tariffs or change the laws regulating a particular market)
- Rising or falling currency exchange rates (may make the value of your overseas investments worth less in Australian dollar terms)
- Shifts in interest rates (the RBA or central banks lifting or cutting rates)
- Changes in market sentiment (like sharemarket investors becoming more fearful the market will fall).
When market events occur, they can have a significant impact on the assets your super fund has invested in. For example, tighter economic conditions may wipe some of the value off your share investments due to the expectation that companies will face tougher operating conditions.
Another example is changes in interest rates, which can reduce the value of bonds and fixed interest assets. This is because the market value of a particular bond your fund owns may decline if official interest rates rise.
Super funds manage market risk by setting a long-term strategic asset allocation, within a certain range, which outlines the planned allocation to each asset class within each of the pre-mixed investment options they offer. Rather than reacting to every change in market conditions, the strategic allocation helps keep the focus on long-term performance. However, funds can make short-term strategic adjustments to their asset allocation, withing the target range, in response to market conditions.
2. Liquidity risk
This is the risk you can’t sell your asset at a fair price when you want to cash it in. You may need to sell at a lower price if you want to get your money out of the market.
In some situations, it may not be possible to sell the investment at all. This was the position some investors found themselves in during the GFC when certain asset markets became ‘illiquid’ – or without buyers.
For a super fund, a lack of market liquidity makes it difficult to sell investments or raise sufficient cash to meet its commitments to fund members at a particular point in time.
Super funds are required by the Australian Prudential Regulation Authority (APRA) to have a liquidity management plan that is stress-tested against poor outcomes.
3. Concentration risk
This is the risk of losing money because your portfolio is overly concentrated in one particular asset or class of investments.
This is more of an issue for people with a self-managed super fund (SMSF). For example, if the majority of your SMSF’s assets are invested in a single investment property or a small number of Australian shares, you face significant concentration risk, as your portfolio is not diversified over a range of asset classes, industries and geographic locations.
The best protection against concentration risk is diversification. That’s why ‘Don’t put all your eggs in one basket’ remains a key investment rule. Big super funds always spread their investments across a variety of asset classes, including those outside the familiar ones like shares and cash.
By diversifying across and within asset classes, your super fund aims to reduce the impact of volatility within a single asset class. It also means the super fund’s investment returns are not reliant on a single asset class performing well all the time.
4. Credit risk
This is the risk a bond issuer will run into financial difficulties and will not be able to fulfil its contractual obligation to pay the promised interest or repay the loan amount (principal) at maturity.
Bond issuers include governments, government agencies and companies. If they fail to meet their obligations, there’s a financial loss to your super fund.
The level of credit risk is denoted by the credit rating of the bond. For example, a 10-year Australian Government bond has a credit rating of AAA, which is the highest possible rating and the lowest possible credit risk. A rating below BBB- is regarded as non-investment grade/highly speculative while D signifies the issuer is in default.
5. Reinvestment risk
This is the risk an investor faces when it comes time to reinvest their principal or income and the interest rates on offer are lower than previously available. For example, say your super fund has invested in a bond paying a 5% return, but when the bond matures and the fund looks to reinvest, it may only be able to find bonds offering a 3.5% return.
6. Inflation risk
This is the risk you face when the value of an investment is not keeping up with inflation.
Rising inflation is a significant risk if you’re invested in cash or bonds, as the investment return from these asset classes tends to be more stable. Shares and property on the other hand, offer some protection against rising inflation as companies and landlords can increase their prices or rents.
Ensuring your portfolio has adequate exposure to growth assets is the simplest way to manage inflation risk.
7. Horizon risk
This is the risk your investment horizon – or time you have to invest – may be shortened due to an unforeseen event such as becoming ill or losing your job.
In this situation, you could be forced to sell an asset you were expecting to own for a longer period at a loss during a market slump.
The best way to manage the horizon risks of illness, injury or premature death is to have appropriate and adequate insurance cover.
8. Overseas (or country) investment risk
This is the risk you face when you invest in offshore assets.
Investments outside Australia are exposed to risks that may not apply at home. For example, when you buy shares in companies in emerging market countries there is a risk the government could decide to nationalise the company or industry. When you buy overseas investments, you are also exposed to currency risk if there are adverse movements in the Australian dollar exchange rate. Offshore investments also face different economic conditions and different regulations.
9. Investment manager risk
This is the risk that comes with using an investment manager – even when that investment manager is you.
Although investment managers try to understand and manage all the various risks that come with investing, they don’t always get it right. There’s a risk the manager – or you – will not do as well as the broader investment market. Which means you have lost money compared to what you could have achieved from investing with another manager or via an index fund that simply replicates market performance. Actively managed investments are also more expensive than index options.
Most large super funds use active investment management to access complex investments or unlisted assets. It can also be useful to get exposure to a particular manager’s style. Along with actively managed investments, it is common for super funds to also use indexed options to lower costs and reduce investment manager risk in their portfolio.
Some super funds blend active and passive investing in a core plus satellite investment approach. This involves investing the core of the super fund’s portfolio in index investments, with the remainder being invested in actively managed satellites that have the potential to deliver higher returns.