Fixed Interest sometimes seems like the easy and only alternative. Is it really as safe as it appears?
If the question relates to our ability to become, and to remain, financially independent then the answer to both questions is no.
Fixed interest will certainly do part of the job – and for very conservative investors more than that – but we need to carefully consider the pros and cons first.
Of those who have been financially successful in life and who wish to remain financially independent there will be very few who will feel comfortable relying on a diet of fixed interest only. And yet these people can often be very risk averse at the same time.
Investors often chase higher finance company and capital note issues without any regard to the extra margin of risk above a bank rate. Finance companies have fallen over in the past, for instance, and there is no reason to suspect that history will not occasionally repeat itself.
What are some of the issues:
• Inflation is a key issue.
• Smaller longer term returns and therefore a risk of funds not lasting as long as they could have
• Locking in below market returns
• Capital security (particular non-bank deposits)
• Reinvestment rate risk
• Lack of active management
Below is a story which illustrates the potential danger represented by inflation -
“Young fellow, you might be interested to hear a real story about inflation. I retired in 1974, with a lump sum of $100,000. In those days that was a lot of money - you could buy 25 Holden Kingswoods for that. Like the sensible bloke I was, I put it in the bank at 8 per cent. The interest I received was enough to buy two Kingswoods a year, so I thought I’d be right for my retirement. But it didn’t turn out that way because of inflation.
Do you know what $100,000 can buy you now?
About four Holden Commodores.
The real problem though is that I don’t even have the $100,000 left. I started living on the interest, but inflation meant that as the years went by it wasn’t enough. I had to start eating into some of the $100,000 each year, so it was $90,000 after a couple of years, then $75,000 a couple of years later, then $50,000. Then within a few more years it was nothing. So now I’m living on the pension.
That’s what inflation is my friend”.
If inflation is 2% per year for the next 10 years the purchasing power of $100,000 will have dropped to $83,375 and in 20 years at 3% to $56,060. So, even at 2% or 3%, inflation can have an impact on capital.
The antidote to inflation is to have an element of growth in the investment structure.
Fixed interest appears to be the simplest answer. But it is definitely not the safest.
