The SRI of investing in bonds (or savings) and investing in stocks is far apart. However, the SRI only looks at the short term and doesn’t account for inflation. In the long term, the risk of investing in stocks actually decreases, while the inflation risk for investing in bonds (or savings) increases. As a result, the difference in risk between bonds (or savings) and stocks is ultimately smaller than the SRI suggests.
What Does the SRI Measure?
When investing, you’ll encounter the Summary Risk Indicator (SRI) with a scale from 1 (low risk) to 7 (high risk). Investment funds targeting retail investors are required to display this. The goal is simple: to give investors an idea of the total risk at a glance.
The SRI is primarily based on a fund’s price fluctuations over the past five years. Because equity funds fluctuate more, they receive a high SRI score of 4 to 7. Bond funds receive a low score of 1 or 2. Savings don’t have an SRI score but would come out as 1.
What does the risk indicator measure?
The risk indicator looks at value fluctuations in the past. The larger these fluctuations, the higher the score. It’s not a guarantee of future returns, but it does provide a realistic picture of the risk.
Why is the SRI Incomplete?
The SRI doesn’t tell the whole story, which European regulators themselves (ESMA, FCA) and stakeholders (Better Finance) also acknowledge. It doesn’t take into account the inflation risk and the decreasing risks of investing over the long term.
The Hidden Risk: Inflation
The SRI doesn’t account for inflation: the risk that your money loses value. Thus, bond funds seem safe due to their low SRI, and savings also feel safe, but the interest rate is often lower than inflation. Over a longer period, you then lose purchasing power.
Equity funds (like UpToMore) do have a higher SRI, but historically, their returns have been higher than inflation, so you maintain your purchasing power in the long term.
If the SRI were to include the inflation risk for an investment in the long term, the score for bond funds would likely be higher.
Why Investing for the Long Term is so Important
Time is the best protection against risks. If you can set aside your money for more than five years, investing in a broadly diversified equity fund offers good protection against risks:
- Market recovery: While past performance doesn’t guarantee future results, so far, market declines have always been followed by recovery. If you have a long horizon, you can ‘ride out’ declines and don’t need to sell your investments when the market is down.
- Protection against inflation: In the long term, your risk consists of two components: price decline and loss of purchasing power, or inflation. A price decline can be a big shock, but historically it’s often temporary. The effect of inflation, on the other hand, is permanent and can, unnoticed, erode the value of your assets. Historically, equity funds have yielded higher returns than inflation, so the purchasing power of your assets grows.