Five investment risks you don't know you are taking
1 Lack of income protection
Around 60% of people do not have any kind of protection product, according to life company Bright Grey, with one in five people believing cover to be unnecessary. But what happens if your income suddenly disappears?
"Your income is the bedrock of everything you do," says Roger Edwards, propositions director at Bright Grey. "A salary is usually your entire financial existence. If it disappears, how on earth are you going to afford anything? You'll need to replace that if you stop working."
Edwards says most people buy life insurance before any type of income protection cover, as the monthly premiums are typically much cheaper. For a non-smoking man aged 30 on his next birthday, a monthly life cover premium costs around £10.03. The same man buying income protection would pay around £13.86 monthly premium.
While it's still important to have life insurance, income protection - which covers your income if you are unable to work due to illness, also needs to be considered.
The statistics speak for themselves: research from life company MetLife shows that 21% of the working population have been off work for four weeks or more due to illness, yet only 15% have any insurance to protect them when this happens.
"If you're young, the likelihood is that you're not going to die, but more likely to need an income protection policy, especially if you have a family and a sizeable mortgage," Edwards adds.
To find the right policy, Edwards doesn't recommend just "picking the best-buy from a comparison site". Instead, he says: "Sit down face-to-face with an adviser. Some policies have exclusions that they won't pay out for, and consumers can miss the small print."
2 Sovereign bonds
With continued uncertainty plaguing the markets, investors have piled into gilts and other high-quality sovereign bonds. While they come with a guarantee that's as safe as the issuing country, German 10-year Bunds are currently yielding around 1.42%, and two-year Bunds are actually yielding 0%. UK gilts are yielding slightly more, hovering around the 1.7% mark for 10-year bonds.
However, for the price of security, investors are paying in real returns. The Consumer Prices Index measure of inflation stood at 2.8% in May, while the Retail Prices Index (RPI), which includes mortgage payments, is at 3.5%.
"Our view is that there are a lot of investors out there holding government debt with the belief that it is a safe haven,' says Tim Walsham, chartered financial planner at BRB Wealth Management.
"The reality is, with yields at their current low levels, there is a huge potential risk to capital. We prefer to invest in a range of very high-quality, short-dated global bonds, thus keeping the risk to a minimum."
Cash savers are also losing money in real terms. "When investing in cash deposits, the effects of inflation are often overlooked," says Paul Taylor, managing director of financial advisers McCarthy Taylor.
"The interest rate on a deposit account may be only 0.5% but inflation is 3% - that's a loss in real terms of 2.5% after one year. This has a compounding effect, meaning the value of cash in real terms can be worth significantly less over time."
3 Structured savings bonds
With inflation remaining at elevated levels, several attractive inflation-linked products have appeared on the market, all with the "guarantee' of a decent return.
Firms such as Santander, Legal & General and Barclays offer structured savings bonds, which typically masquerade as long-term savings accounts. They are often labelled "capital guarantee' or "structured savings", when actually they are linked to the performance of an investment such as the FTSE 100.
They are classed as savings, but behave more like an investment and are guaranteed by a counterparty, which could be a poorly capitalised financial institution.
As an example, Santander offers an "inflation-linked savings bond", which pays interest of either 105% of the growth in the RPI, or 17%gross at the end of the six-year term. Santander UK is the counterparty for the bond, which means the bank has a ring-fenced fund that invests in the stock market on the account's behalf, so savers' money is not affected.
That said, the FSCS might not always apply to structured savings bonds, an issue that landed Santander in hot water. In February, the Financial Services Authority fined the bank £1.5 million for misleading customers, who opened 178,000 Guaranteed Capital Plus and Guaranteed Growth Plan accounts. It told savers they would be covered by the FSCS if the bank went bust, but this is untrue.
Adrian Lowcock, senior investment adviser at Bestinvest, says although these products can deliver inflation-beating returns, investors should be wary of the term "guaranteed capital return".
"The return is not guaranteed as it is supported by a counterparty, usually a bank, so the investment is indirectly an exposure to bank debt," he adds. "Here lies one of the major issues - at present we would not recommend an investor to get exposure to bank debt - the eurozone crisis has put pressure on Europe's banks and the risks are huge, so we only like the highest-quality counterparties, and HBSC is the only one."
Mike Connolly, spokesperson for Legal & General, admits that although some L&G accounts are labelled "capital guaranteed", the accounts without "deposit" in their name will typically not be covered by the FSCS.
If you are considering buying one of these products, check first whether it is covered by the FSCS.
4 The wrong risk category
Understanding your attitude to risk is at the heart of the investments you make. Normally, the longer your investment horizon the more risk you can take, although this isn't the case for everybody. It's important to get a sense of what kind of risk you are happy with, and reassess it regularly.
Andy Brown, investment director at Prudential, suggests using a behavioural-type risk tool such as FinaMetrica, which costs £30 per profile for private investors, to help you identify your level of risk. "Work out what your long-term 'aptitude' to risk is, and what your 'tolerance' - how you feel about immediate market events affecting your portfolio - to risk is," he says.
Brown believes investors should re-test themselves at least once a year in case investment goals or attitudes to risk have changed, or if the market situation has changed dramatically.
Meanwhile, be wary of funds labelled "cautious", "balanced" or "adventurous". Investors might think they are investing in a cautious fund, but the word "cautious" can mean different things to different people.
He advises using multi-asset funds and multi-manager funds, which can be a good way to spread the risk across a range of different assets, as they invest across the market spectrum and don't rely on just one asset class or geography to perform.
"Ask yourself: how would you feel if the market drops suddenly? Then organise your investments around that," Brown concludes.
5 FSCS limits
The deposit protection scheme, the FSCS, protects UK cash deposits up to £85,000, and investments up to £50,000 if a firm were to go bust. Elsewhere in the European Economic Area, cash deposits are protected up to €100,000.
However, some banks and building societies come under the same umbrella and share the compensation limit with another financial institution.
For example, Halifax, Bank of Scotland and Birmingham Midshires are all part of the HBOS group, and savers with the group are entitled to just £85,000 spread across all three. That said, some linked banks retain separate compensation licences.
M&S Money, part of banking giant HSBC, has a separate FSCS limit of £85,000. It's essential to understand how your savings are protected and under which financial group they are classed.
Santander UK, the UK arm of Spanish bank Banco Santander, was recently downgraded by credit ratings agency Moody's, reflecting the increased uncertainty surrounding the European banking system. However, Santander UK is an autonomous unit of Banco Santander in Spain, and any money raised in the UK stays in the country.
"If you are worried about such risks make sure you know who the parent company or the ultimate deposit taker is and think about investing in government-backed National Savings & Investments," says Taylor.
In addition, if you have an offset mortgage with a bank or building society that subsequently goes bust, you will be entitled to £85,000 worth of FSCS cover. For savings balances over this amount, the rest of the savings balance is typically paid directly back into the mortgage.
This article was written for our sister publication Money Observer
Investment funds that invest in other investment funds from a wide range of asset managers and are often referred to as funds of funds. Some multi-manager funds only invest in the funds of the investment house providing the fund of funds and these are known as “fettered”. An “unfettered” multi-manager fund is free to invest in what the fund manager believes are the top performing funds from across different markets and industries. Investing in multi-manager funds means your risks are spread across geographical regions and industry sectors but it also adds another layer of charges and some multi-managers also levy an out-performance fee.
A way of combining a mortgage and savings so the savings “offset” and reduce the mortgage. Rather than earning interest on savings, the savings reduce the mortgage and the interest paid on the borrowing, so savings are effectively earning interest at a higher rate than most mainstream savings accounts will pay. They are also tax-efficient, as savers avoid paying tax on interest that their deposits would otherwise have earned. Offset mortgages offer the disciplined borrower a great deal of flexibility, as overpayments can be made to reduce the term or monthly mortgage repayments, which can save thousands of pounds in interest payments over the mortgage term.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
Generally thought of as being interchangeable with life assurance, but isn’t. Life insurance insures you for a specific period of time, at a premium fixed by your age, health and the amount the life is insured for. If you die while the policy is in force, the insurance company pays the claim. However, if you survive to the end of the term or cease paying the premiums, the policy is finished and has no remaining value whatsoever as it only has any value if you have a claim. For this reason, life insurance is much cheaper than life assurance (also called whole of life).
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The Financial Services Compensation Scheme is the compensation fund of last resort for customers of authorised financial services firms. If a firm becomes insolvent or ceases trading, the FSCS may be able to pay compensation to its customers. Limits apply to how much compensation the FSCS is able to pay, and those limits vary between different types of financial products. However, to qualify for compensation, the firm you were dealing with must be authorised by the Financial Services Authority (FSA).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
This is a mutual organisation owned by its members and not by shareholders. These societies offer a range of financial services but have historically concentrated on taking deposits from savers and lending the money to borrowers as mortgages, hence the name. In the mid-1990s many societies “demutualised” and became banks. One academic study (Heffernan, 2003) found demutualised societies’ pricing on deposits and mortgages was more favourable to shareholders than to customers, with the remaining mutual building societies offering consistently better rates. In 1900, there were 2,286 building societies in the UK; in 2011, there are just 51.