What is risk? – Bank accounts and Cash
RISK: The dictionary definition: exposure to the chance of injury or loss; a hazard or dangerous chance.
We all think the concept of LOSS as being the principle financial risk, but there are different types of risk which can affect the value of our capital and the return we get from it;
The safest form of investment asset is considered to be CASH, but what are the risks (OF LOSS) if I hold €100,000 in my French bank account?
Counterparty & Jurisdictional Risk
If my bank (my counterparty) goes bust the French (my jurisdiction) government will currently underwrite the first €100,000 of all individual deposits. If I bank with a big name in a well protected jurisdiction I should be ok, but should I move the excess to another bank to reduce risk?
Inflation Risk
With time the COSTs of goods and services tend to increase; this eats away at the real value of money or ‘it’s buying power’. Today global inflation is approximately 2.5%p.a.
But that’s not the whole story as inflation is based on an average ’basket of goods and services’. At different stages of our lives the inflation of different elements within the ‘basket’ can vary: The cost of living might drop for a family with a mortgage when interest rates fall, but an elderly couple with food and fuel bills, and no mortgage feels the pinch as oil, coal and food prices rise.
Interest rate risk
The bank pays me interest on my money and lends it out at a higher rate and pockets the difference as profit. If interest rates are high I am taking risk that my return may fall; can I get a similar return for similar risk elsewhere?
If interest rates are low, like today, then I am swapping interest rate risk for inflation risk by having my money on account. It is therefore the amount of my return OVER INFLATION which should be my only concern when looking at the amount of risk I am willing to take.
Today if I am lucky enough to earn 0.5% interest it means I am losing 2% per year…. guaranteed.
Default risk
The bank should continue to pay me the interest as it receives it from its lenders. There is a small risk here if I choose a weaker bank.
But by banking my money I am NOT taking the following risks:
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- Liquidity risk – I can get to my money anytime.
- Investment risk (volatility of returns) – my money is just in a bank account, the interest may change a tiny amount but the capital value remains stable (except for inflation).
- Opportunity risk – as my money is not tied up I can use it to buy any sudden opportunities that come along (once I understand the risk/return swap).
This article is for information only and should not be considered as advice. This article is written by Peter Brooke The Spectrum IFA Group