Five investment risks you don't know you are taking

9 July 2012

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.

This account is also covered by the Financial Services Compensation Scheme (FSCS) as it is labelled as a "deposit-type" product, despite being partly invested in an investment.

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

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