Risk. Isn’t risk the reason so many people fear the stock market? Risk in the stock market is only one of many forms of risk. There are safe, conservative, even guaranteed, forms of savings that have risks. Managing money in any form of savings or investment vehicle involves risks.
It is important to understand what risks you face so you can manage the risks associated with your money.
Here are some of the more common forms of risks.
Inflation risk – your money is worth less over time due to inflation. This is a very common form of risk that we readily accept. This form of risk is dangerous because it is sneaky. Your principal does not decline so you don’t see the deterioration of your account value.
This risk exists in accounts where the interest rate does not offset the impact of inflation or taxes. A prime example is people saving in the TSP G Fund. Or people with low rate CDs. Or people with a pension or insurance annuity without an inflation adjustment applied to the income payments.
Examples: A) $10,000 today is worth $7374 10 years from now at 3% inflation. Considering the inflation rate of housing, food, energy, education and medical costs, the erosion of account value could be worse. B) A $1000 a month pension at age 65. Most pensions do not have a cost of living adjustment each year. What’s a $1000 a month worth by age 90?
Interest rate risk – fluctuating federal interest rates impact bond values. If you buy an individual bond and hold it until maturity, your bond value is stable (however what has inflation risk done to your bond’s value?).
If interest rates go up to 4% and you are holding a 3% bond, your bond is worth less if you try to sell it. Same with your bond mutual fund’s share value. Now on the other hand, if you are holding a 3% bond and interest rates go down, your bond is worth more.
Liquidity risk – when you can’t buy or sell an investment when needed for cash or quick enough to prevent a loss. Typically this applies if you are trying to sell an investment when the price is falling or you need the cash quickly for an emergency.
How fast can you get cash from a mutual fund or a specialty investment like a non-traded REIT for example? This risk is usually associated with thinly traded securities—investments where there is not much buying and selling. Examples are a small company stock or a proprietary product.
Reinvestment risk – inability to get out of one savings vehicle and into another without a loss of cash flow. A typical example here is a CD or a bond matures and the only available CDs and bonds have lower interest rates.
Market risk – value of your investment hinges on a market direction. The most common known risk. Everyone’s afraid of their portfolio value decreasing in a down market. Owning an investment that is linked to a market enhances this form of risk.
Transferred risk – not assuming a financial risk yourself but decide to buy insurance to transfer the risk elsewhere. The common forms of transferred risks are life, medical, home and auto insurances. Only the wealthy and some companies tend to self-insure; assume the financial risks themselves.
Besides these forms of risks above, there is business risk, credit risk, exchange risk, political risk, systematic risk, unsystematic risk, call risk, default risk, on and on.
What’s my point? It is that money issues have risks; all money issues. You need to understand money risk management to ensure you meet your financial objectives.
Benjamin Graham wrote that investment management is about the management of the risks and not the management of the returns. Yet, the majority of investors manage to the return because that is considered the essence of investing. In other words, chasing returns is what gets us into trouble. Chasing returns contributes to us taking on too much risk.
“I need to get 15% on this investment for me to retire comfortably.”
“This fund should get 11% this year.”
“That fund got 18% last year.”
“Build a million dollar portfolio using these funds now!”
“I’m staying in the G Fund to protect my principal and earn a stable return.”
Don’t we manage investments comparing our performance results to a benchmark or by looking at our YTD, 1-year, 3-year, 5-year, 10-year returns? Not to say returns are not an important consideration in our selection criteria but we should be managing our investments primarily by managing the risk we assume. The returns will follow as a by-product.
Methods for managing risks include:
- If you know you are losing value in your savings account due to inflation risk, you could implement other strategies in other accounts to mitigate the inflation risks in the savings account. Inflation risk is a necessary evil because we all need accounts that are liquid and stable.
- If you are closing in on retirement and you will be living off your investments, you could reconfigure your portfolio to reduce portfolio volatility while also maintaining some growth potential for a long lifetime. Have a balanced allocation of stocks, bonds, cash, real estate, and so forth. Or have separate accounts based on various time periods and manage each account according to its time period; near–term in conservative savings and long-term accounts in more aggressive investments.
- Because we can’t predict market movements, you could take advantage of the movements by averaging down in your investments thereby exploiting market volatility. When averaging down, normal stock market drops stop being a risk and start being an opportunity to buy more shares. You actually need and want stock market declines.
- You could rebalance your portfolio’s investments when individual holdings get over or under weight. Rebalancing to maintain a specific portfolio allocation forces you to buy low and sell high which enhances your value over time. Rebalance when values get 10 to 20% outside your portfolio allocation ranges.
Whether your portfolio objective is growth or income, vary your holdings so you don’t hold all the same type of investments. For instance:
- An income portfolio may have bonds, CDs, preferred stocks, convertible bonds, insurance annuities, floating-rate loans, high-yield bonds, international bonds, closed-end funds, mutual funds, municipal bonds or rental properties you own. If you consider your pension and Social Security in the mix of income generators, it may allow you to be more aggressive with your other income investments.
- A growth portfolio could include stocks, REITs, mutual funds (indexed or managed), ETFs, commodities, private money managers, variable annuities, property ownership, business partnerships…
Income you generate from work, whether retired or not, is a type of investment and allows you to consider your portfolio investments in another light.
Having a handle on risk management can open the door to more options when managing your portfolios. It can also help improve your long term results by not getting stuck in an either-or situation.