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Financial planning 101: Evaluating risk from a broad perspective (Part 2)

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IN our previous article on risk, we highlighted some commonly known risks in investing – market risk, liquidity risk and inflation risk. Now, let us explore more on the topic.

Does high risk equal to high returns?

IN our previous article on risk, we highlighted some commonly known risks in investing – market risk, liquidity risk and inflation risk. Now, let us explore more on the topic.

Does high risk equal to high returns?

Generally, in order to achieve higher returns, we have to be prepared to take on higher risks. Take for example the risk/return relationship from the stock market and a savings account.

Due to the higher risks (price fluctuations, market risks and other risks), an investor assumes that by investing in the stock market, he should be better compensated for the risk he is taking in the form of higher returns.

On the other hand, by placing his money in the bank account, the investor can be sure that the returns promised is certain and predictable – without being affected by price volatility or market risks.

This evidently comes with lower returns. The risk here is that the ‘certainty’ in returns means the nest egg fails to keep up with inflation.

Danny Wong Teck Meng

Inflationary pressure

But before we conclude that high risk equals to high returns and low risk equals to low returns, let us look at a common life goal:

Notice how everyone wishes that they are a millionaire? If you still aim at making your first million in the next decade, we have some bad news for you.

In 2028, amid the present value terms and headline inflation running at 5%, that RM1,000,000 will only be worth RM613,913 today. You will still be a millionaire but look at how much your purchasing power has been eroded.

In this regard, we hope you have input an appropriate rate of inflation into your retirement calculation. Underestimating the effects of inflation can lead to a faster-than-expected rate of capital attrition.

The inflationary effect becomes even more pronounced over time and accelerates as inflation climbs.

Some retirees may put their entire nest egg into a savings account for its ‘safe’ features. In the face of high inflation, however, that low risk, low return vehicle may turn out to be low return but high risk instead.

Conclusion

Equities has historically been proven to be a good hedge against inflation. If you are still young, and your investment horizon is long, your investment has enough time to recover from any market downturns.

Invest consistently, even when markets come down. Look at the bigger picture.

For retirees, do not shun away from equity risk either. Even a 10%-20% allocation in equities can help to boost your retirement portfolio and help generate returns which are at least in line or above the inflation rate.

Building wealth over time or even to sustain your purchasing power requires some form of risk-taking. This can be a calculated move to take on more risks. Start with the end goal of investing in mind and work towards optimising your portfolio returns.

We hope this article has changed your perspective on risk.

 

Danny Wong Teck Meng, CFP is the CEO of Areca Capital Sdn Bhd and a certified member of the Financial Planning Association of Malaysia (FPAM).

Originally published on
https://focusmalaysia.my/financial-planning-101-evaluating-risk-from-a-broad-perspective-part-2/
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