Understanding risk

One of the challenging things about investing is the higher the returns you aim for, the greater the risk.

Risk vs return

There are some ways to manage the trade-off between risk and return that may be worth considering.

1. Invest to suit your timeframe

If you don't need your super straight away, you have more time to ride out the highs and lows of growth investments.

So, it's important that you link your investor style with your timeframe for investment.

Your investment timeframe is the amount of time you expect your money to remain invested. Generally, the longer the investment timeframe, the higher the level of risk you may tolerate when selecting your investment option. A longer timeframe for investment means you have more time to ride out short term fluctuations in investment markets in order to gain long term growth.

The shorter your timeframe for investment, the less aggressive your investment style may be. Investors with a limited timeframe for investment may not want to risk short term fluctuations in investment returns and therefore opt for a more conservative approach, with the aim of protecting investment capital.

It is important to remember that you will probably have different investment timeframes for different financial goals that need to be met by the one investment. For example a recent retiree will have different timeframes for different stages of retirement and their investment may also be split to accommodate different financial needs. Money that is required to live off in the short term may be invested more conservatively than money that is needed to fund the later years of retirement which could be 20 or 30 years in the future.

Each asset class has varying timeframes for investment, based on its level of risk or potential fluctuation in returns. For example, more conservative assets such as cash or fixed interest may not offer you high returns in the short term, however are considered more stable than other asset classes such as shares, therefore suiting people with a shorter timeframe for investment.

2. Diversify your investment to help minimise risk

Diversification is simply a term for spreading risk. It can be achieved by placing your investment in a mix of growth and financial assets, such as shares, fixed interest, property and cash. This way, when one asset is not performing as well as expected, the other assets in your portfolio may help to balance the overall return. You've heard the saying, 'don't put all your eggs in one basket'. Apply this concept to investing and it can help reduce the impact of negative returns on your investment.

Telstra Super also achieves diversification by selecting a wide range of specialist investment managers. This means that different specialists in each asset type manage your money, which also helps spread the risk. Each manager is carefully chosen to provide competitive performance as well as specialist skills in particular markets.

3. Beat inflation

Nothing makes the need to start saving and investing right away more apparent than the effect of inflation. Put simply, inflation decreases the value of your dollar, meaning that over time you need more money to purchase the same goods.

The following illustration represents $100 worth of groceries at various points in time.

$100 worth of groceries 1987, 1997, 2007.

Source: Telstra Super Financial Planning
Assumptions: based on CPI figures from 31 March 1988, 1998 and 2008.

So, if your investment does not earn the kind of returns you need to keep up with rising costs, there is a chance that you will not earn enough to fund your retirement goals. That's why it is important that your investment can keep up with, and beat, rising costs due to inflation.

4. Take advantage of compound interest

Compounding is the process where your investment receives earnings so your investment grows and you then receive earnings on this larger investment. By investing in your super fund, all the contributions and earnings compound and grow until your benefit is paid.

If you think about compounding in terms of earnings on earnings, then you will see that this is one of the most powerful ways your investment can grow over the long term. Let's take a look at a case study of two friends.

Case study - compounding interest

Joanne has decided to make the commitment to put aside $30 each week for the next 30 years. She decides to put this into her super where it will be preserved and she won't be tempted to spend it. Her friend Lisa thinks she's too young to start making her own contributions to super, so she doesn't save anything.

After 15 years, Lisa starts feeling guilty about not saving so she decides to contribute $60 each week saying, "if I save double what Joanne is saving over half the time, I'm sure to catch up with her savings in the end".

The graph tracks their savings over the 30 year period and shows the difference achieved by compounding returns over a longer period of time.

Even though they both contribute the same amount overall, Joanne ends up with almost double the savings, all because of compound earnings over a longer time.

Source: Telstra Super Financial Planning
Assumptions: Interest rate of 7% pa. This example does not take into account an assumed change in the cost of living between when this example was prepared and the future. $60 per week invested at 7% pa over 15 years compounding vs $30 per week invested at 7% pa over 30 years compounding. No fees and taxes are taken into consideration. Past performance is not a reliable indicator of future performance.

Types of risk

When investing there can be many risks to consider. You need to be aware that super laws and tax laws change often and this can impact your investments. Also, the investment option you choose will change in value over time and may perform differently at different times, due to various factors.

The following table highlights some of the risks you may need to consider when making an investment:

Risk Explanation
Inflation risk Inflation may exceed the return on your investment.
Individual investment risk The investment option you choose may drop in value.
Market risk Changes in investment markets due to economic or political factors may occur, possibly causing changes in your investments.
Interest rate risk Changes to interest rates may impact on investment returns.
Currency risk Telstra Super invests in overseas investment and if the currency of those countries rises or falls, or if the Australian dollar rises and falls, the value of your investment may change.
Derivative risk Telstra Super uses derivatives to reduce risk, reduce transaction costs and as an efficient way to gain exposure to asset classes. Derivatives are not used for speculative purposes or for gearing. Risks associated with derivatives include the value of the derivative falling. We aim to minimise derivative risk by constantly monitoring the fund's use of derivative contracts and by entering into derivative contracts with reputable parties.
Changes to super law Super laws change often and these changes may affect your investment.
Changes to tax law Tax laws change often and these changes may affect your investment.
Manager risk The risk an investment manager will not perform to expectation. Telstra Super's manager risk is reduced through using a diverse range of specialist investment managers chosen to provide competitive performance as well as specialist skills. Performance is carefully monitored and managed.