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Isn’t investing risky?

Shares carry risk, but historically they also offer the best chance of beating inflation.

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by Ian Smith on Jun 01, 2010 at 00:01

Investing in the stock market is often seen as high risk, especially after the turmoil of the credit crunch which devastated world markets in 2008.

Hardly surprising then that so many potential investors prefer to opt for what they see as low risk investments - especially cash..

Think cash really is safe? Well, it is true that if you choose a savings account at a reputable high street bank, it is most unlikely to go bust. Spread your money around different institutions (no more than £50,000 at each one) and you should be covered by government guarantees. The Northern Rock scare of 2007 - the first run on a UK bank for more than a century - frightened many people but even then the government stepped in when needed.

But that's not what we're talking about here.  We're talking about the insidious effects of inflation on cash savings, especially when interest rates are as low as they are now.

Study the numbers

Do the math, as the Americans say. The UK inflation rate (as of April 2010) is 3.7% and you'll be lucky to get 2.5% in a savings account right now. The effective rate is even lower if you pay higher rate tax. Every year, your income from these cash investments will fall behind the rising cost of living, an effect that compounds year on year in a pretty vicious manner.

An annual study from Barclays Capital shows what's happened over time. If you'd put £100 in the stock market in 1945 and reinvested your income it would now be worth just over £4,000 in inflation adjusted terms.

But if you'd put it in the building society it would be only worth £206. It's proof that stock market investments are typically better at combating the risks of inflation. Historically, over the medium to long-term, investing in shares has produced the best returns, although they can still be volatile in the short term.

So do I invest it all in shares then?

No. But you should have some exposure to shares – the exact proportion being determined by factors such as your age, your plans and your appetite for risk. 

Ideally you'll have a portfolio that mixes shares, bonds and possibly some other assets such as commercial property and commodities that won't all swing one way up or down together. And yes, some cash as well for when you need to pay for something in a hurry.

It's called asset allocation and there's no magic formula that applies to everyone. But you'll see what makes sense for you if you give the subject matter a little attention. Keep reading Citywire is a good start – there's a fine article on the subject by Mike Deverell, a well-respected financial planner, which is well worth taking a peek at.   

Ian Smith of Central Financial Planning can be contacted at ian@centralfinancialplanning.co.uk or 0845 0066 204

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