Understanding Risk — Pick Your Poison!

Currently, the public is quite focused on volatility. This is otherwise known as Market Risk—referring to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political or other of a myriad of risk factors.

Recently, you may have heard me describe that there are two main risks that our clients choose from—either market risk, inflation risk, or both. Inflation Risk, also called Purchasing Power Risk, refers to the possibility that general prices will rise, and one’s ability to purchase goods and services would decline. So, if we do not invest in a long-term portfolio that will generate solid returns (6% per year or more) to combat inflation, we might not be able to purchase all we need, and in retirement we could face the specter of running out of our funds during our lifetime. This is a serious risk often overlooked by risk averse people who shun the volatility of the stock market completely, or to any significant degree, by keeping balances in the bank instead of investing for the long term.

At BWFA we encourage clients to assume volatility (market risk) and avoid assuming the purchasing power risk. In most cases, clients rely on their savings to sustain them in the retirement years (decades!!). So, they really ought to choose this market risk, risk that is mitigated greatly by investing prudently and over the long run through your advisor.

There are other types of risks besides the two previously described:

  • INTEREST RATE RISK: bonds’ values will fluctuate up or down given changes in interest rates. Right now, with interest rates trending higher, the values will go down given the inverse relationship between rates and the values of the bonds or other interest rate sensitive investments. At this writing, BWFA is careful in this area as the interest rate risk can be substantial given these rising interest rates.
  • REINVESTMENT RISK: this refers to the risk that you may not be able to maintain the same rate of investment. Have you ever heard of someone taking money from a maturing CD or bond and reinvesting at a much lower rate of interest? That was a common reoccurring risk over the last 30 years as interest rates dropped from the highs of the 1970s to where they have been in the last few years. 
  • DEFAULT RISK: another risk related to bond investing—there may be a risk that the issuer of a bond, say a corporation or a smaller government jurisdiction, will not be able to pay its bondholders interest or repay the principle at maturity. A stark reality for those who remember the Washington (State) Public Power bonds defaulting in the 1980s, or other high-risk debt defaulting on the books of various shaky corporations throughout the years.
  • LIQUIDITY RISK: this refers to how easily your investments can be converted to cash. More importantly, what is the risk that your investments can be converted easily to cash without significant loss of principle. We utilize various techniques to manage this risk for our clients who need a measure of liquidity in their portfolios.
  • POLITICAL RISK: this relates to risk from new legislation or changes in foreign governments which can adversely affect companies or markets, foreign or domestic, you invest in.
  • CURRENCY RISK: refers to risks that might negatively affect your foreign investments if their corresponding currency reacts negatively related to US dollars, when our clients’ funds are invested in the United States, and in US dollars.

Generally, the more risk you assume, the higher your potential returns, as well as potential losses. No reasonable person will assume a higher risk without the prospect of achieving a higher return. There is a tradeoff. As described above there is a tradeoff between assuming volatility over time versus assuming the risk that your money will run out sooner if you do not achieve the higher returns. 

BWFA aims to maximize returns while taking the appropriate market risk for each individual investor. 

What is your personal desire to assume any risk, and your comfort level with doing so? If you cannot sleep at night because you are worrying too much about your investments, you may be taking too much risk. Your personal circumstances—personality, stage of life, need for funds to grow by a certain amount to support retirement expenses, your current age, any other objectives—factor in to the investment risk decisions you will make.

With 30 years to build a nest egg for younger investors, or 30+ years of retirement for those entering retirement, or even many years for older investors who want to maintain their legacy for their heirs while caring for themselves in the latter years, we all always have time to ride out short term fluctuations as seen in the current environment, in hopes of a greater long term return to achieve our life’s goals.

Joseph Manfredi | MBA | Chief Operating Officer / Senior Portfolio Manager | jmanfredi@bwfa.com