When you hear the word ‘risk,’ you might think of your investments losing value, but it’s a more nuanced concept. Investing can help build financial security, but it involves risks that require thoughtful management. Two key risks to consider are longevity risk and currency risk. This article explains these concepts and offers practical strategies to help you make informed financial decisions for a secure future.
Longevity risk
What is it? This is simply the risk of you outliving your retirement funds. People often save or plan for a certain number of years of retirement. If they live longer than expected, they may outlive their savings/investments.
What can you do about it? It’s often said that starting to invest for retirement as early as possible is one of the best ways to build a nest egg for when you stop working. Beginning to make regular contributions early means that your investments will have more time to have the effects of compounding applied to them.
You should also make sure that, when you do stop working, you’re invested in appropriate assets. Remember, you won’t be earning an income from your job anymore, so you’ll need access to your cash to cover living expenses.
A well-diversified portfolio may help reduce risk and provide more consistent returns, potentially making savings last longer. This could involve a mix of stocks, bonds, real estate, and other assets, depending on an investor’s risk tolerance and retirement goals.
Currency risk
Currency risk, or exchange rate risk, is the possibility that changes in currency values will affect the money you hold, spend, or invest in a foreign currency. For instance, if you invest in assets priced in US dollars and the US dollar weakens against the Australian dollar, your returns will decrease when converted back. Conversely, if the US dollar strengthens, your returns will increase.
This risk applies broadly to transactions involving foreign currencies, such as investments, business dealings, or travel. For example, consider booking accommodation in the US for $1,000 USD. At an exchange rate of 1 USD = 1.50 AUD, it costs $1,500 AUD. If the rate shifts to 1 USD = 1.60 AUD, the same booking will cost $1,600 AUD—an extra $100 AUD due to the currency movement. Alternatively, if the rate drops to 1 USD = 1.40 AUD, the cost decreases to $1,400 AUD, saving you money.
For investors, these fluctuations can significantly impact returns. If the US dollar strengthens against the Australian dollar, the value of US investments increases when converted back to AUD. However, a weaker US dollar reduces the value of those investments. Additionally, a strong US dollar makes initial investments in US assets more expensive for Australian investors. Understanding currency risk is essential for minimising potential losses and optimising gains.
To reduce currency risk, investors could consider diversifying their investments across currencies. By spreading investments across multiple currencies instead of relying on just one, the impact of fluctuations can be reduced. If one currency decreases in value, others in the portfolio may remain stable or increase, helping to balance out the overall impact.
Another option is to invest in hedged ETFs or mutual funds. These products are designed to reduce the effects of currency fluctuations. They use strategies to lock in exchange rates, making returns more stable. While these products may have slightly higher fees, they can help minimise the impact of foreign exchange movements on investments.
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