The Hidden Cost of Playing it Too Safe: Avoiding Investment Risk

It’s completely natural to want to avoid risk, especially when it comes to your hard-earned money. The idea of potentially losing money in investments can be unsettling. Therefore, the thought of avoiding all investment risk altogether might seem like the safest and most sensible approach. However, while aiming for safety is understandable, completely avoiding investment risk actually comes with its own set of significant consequences that can hinder your long-term financial well-being.

What does it mean to avoid all investment risk? In practical terms, this usually means keeping your money primarily in very safe places like basic savings accounts or perhaps holding physical cash. These options are considered “low-risk” or “no-risk” in the sense that you are highly unlikely to lose your initial deposit. Your money is generally safe from market fluctuations or the possibility of a company going bankrupt. This sounds reassuring, right?

The problem arises when we consider the concept of inflation. Inflation is the rate at which the general level of prices for goods and services is rising, and consequently, the purchasing power of currency is falling. Think about it this way: if a loaf of bread costs $3 today, and the inflation rate is 3% per year, that same loaf of bread will likely cost $3.09 next year. While this might seem small in the short term, over many years, the cumulative effect of inflation can be substantial.

Now, let’s connect this to your savings. If your money is sitting in a basic savings account, it likely earns a very minimal interest rate, often less than 1% and sometimes even close to zero. If the inflation rate is higher than the interest rate you are earning, which is often the case, your money is actually losing purchasing power over time. Even though the number in your bank account might stay the same or increase slightly, the real value of that money is decreasing because it can buy less and less as prices rise.

This is the primary consequence of avoiding all investment risk: you are almost guaranteed to lose money in real terms due to inflation eroding its value. Your savings are essentially slowly shrinking in their ability to buy goods and services. This is often referred to as “inflation risk” – the risk that inflation will outpace your returns, even if you haven’t technically “lost” money in the traditional sense.

Beyond inflation risk, there’s also the consequence of missed opportunities. Investing, even with some level of calculated risk, offers the potential for your money to grow at a rate that outpaces inflation. Historically, various types of investments, such as stocks (representing ownership in companies) and bonds (representing loans to governments or companies), have provided returns that are significantly higher than savings account interest rates over the long term. While these investments do carry risk – their values can fluctuate and there is a possibility of losing money – they also offer the potential for growth that can help you build wealth and achieve your financial goals.

By avoiding all investment risk, you are forgoing the potential to earn these higher returns. This means you are missing out on the opportunity to grow your savings faster and potentially reach your financial goals sooner, or even at all. Consider long-term goals like retirement, buying a house, or funding your children’s education. These goals often require significant sums of money. If your money is only growing at a rate slower than inflation, it becomes much harder, if not impossible, to reach these goals through savings alone.

In conclusion, while the idea of avoiding all investment risk might seem appealing for its perceived safety, it actually carries significant hidden costs. The consequences of avoiding risk include the erosion of your purchasing power due to inflation and the missed opportunities for potential growth that could help you achieve your financial aspirations. Instead of completely avoiding risk, a more balanced and effective approach is to understand your own risk tolerance, learn about different types of investments and their associated risks and potential returns, and build a diversified investment strategy that aligns with your financial goals and comfort level. Embracing a degree of calculated risk, rather than avoiding it entirely, is often necessary to secure your financial future and build long-term wealth.