Understanding Investment Risk
| UNDERSTANDING INVESTMENT RISK |
Ask any investor about risk and you’ll probably hear that it’s something the investor wants to avoid or at least keep to a minimum. Like it or not, investment risk is an essential part of any investment decision. Properly managed, risk can be turned to the investor’s advantage. What is risk? The answer depends on whom you ask. If you ask an investor, particularly an inexperienced investor, you’ll probably hear that risk means that you might permanently lose a portion of the money you invest.
To many people, investing (particularly in stocks) is akin to gambling. These people know the risks associated with playing the lottery, betting on a horse race or dropping a coin in a slot machine. When you gamble, there’s a small chance you’ll win big and a big chance you’ll lose everything. That may be true in Las Vegas , but experienced investors know that comparing the investment markets to a gambling casino is a simplistic and unrealistic view of the risks involved in making an investment decision.
To understand investment risk, investors must accept certain fundamental truths of investing. First, there is no such thing as a risk-free investment. Second, investors seeking greater investment rewards must be willing to accept greater risk. Conversely, if an investor is unwilling to accept a given level of risk, then reward expectations should also be lowered. Third, the risks an investor faces can vary depending on how long an investor has to achieve his or her investment goals. Finally, while risk cannot be eliminated, it can be managed through careful planning and following a disciplined investment process.
Let’s look at risk from different perspectives. One form of risk that everyone understands is “principal risk.” That’s the risk that you are exposed to when you purchase an investment (a stock, bond or parcel of real estate) that may suffer a permanent decline in value. For example, if XYZ Corporation goes bankrupt, its bondholders may only receive pennies on the dollar for their interest-bearing bonds and stockholders may see their investment go to zero. The risk that an investment could suffer a significant loss in value due to the changing financial fortunes of the underlying enterprise is a risk of virtually all investments. Only United States government securities and those backed by the federal government (like federally insured certificates of deposit) are presumed to be free of this risk of loss. We assume that our government will always be able to pay its bills.
Another risk investors face is “volatility.” That’s the chance that on any given day, the financial markets might value your investment at a price greater or smaller than it did yesterday. With some investments, the highs are higher, the lows are lower and the journey between the two is faster. Common stock prices of large U.S. corporations tend to be more volatile than the prices of short-term government bonds. Small stocks tend to be more volatile than large stocks. Some foreign markets are more volatile than the U.S. market. Almost all investments are subject to the risk of volatility. Even rock-solid U.S. government bonds and notes fluctuate in value when interest rates move.
A risk that many investors ignore is inflation or purchasing power risk. Inflation is a threat to the long-term health of an investment portfolio. The relatively low (as compared to the double digit rates of the late ’70s and early ’80s) inflation rates of the recent past are actually in line with the long-term average rates over the last six decades or more. Over the period of 1926 through today, the price of a dollar’s worth of goods and services has risen eight-fold, which averages out to about 3 percent per year. Inflation of “only” 3 percent has a corrosive effect on purchasing power over shorter periods as well. For example, over 25 years (the length of retirement for many people) inflation will rob over half of the purchasing power of every dollar if it continues at “only” 3 percent.
The real art of building a successful investment portfolio is balancing and managing risk. One technique to manage risk is through diversification. Diversification simply means spreading your assets over many different investments so that no one investment is too large a portion of the whole. Another technique is to use the differing characteristics of investments to offset some of the risks associated with other investments.
For example, short-term government bonds and certificates of deposit offer no risk of principal loss and little or no price volatility. However, over the long-term they have not been able to keep up with inflation after taxes are deducted. Keep in mind that it’s not what you make but what you keep that matters. Further, it’s not just how many dollars you have left after taxes, but what those dollars will buy that matters.
Common stocks have, historically, provided the growth needed to overcome inflation. The “problem” has been that short-term price volatility scares some inexperienced investors. Blending stocks together with bonds and other investments, in just the right proportions, is essential to building a portfolio that minimizes the many risks of investing.
This process of managing risk, diversifying investments and balancing portfolios is called “asset allocation.” It is, quite simply, the single most important part of the investment decision-making process. It is also a process that requires a careful examination of investor goals, investment experience, other sources of income, tax situations and a variety of other factors. Asset allocation decisions should be made carefully and should not be based on “cookie cutter,” “one size fits all” approaches.
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Clearing Raymond James & Associates, Robin Grier Financial Services, Inc is not an affiliate or Subsidiary of Harbor Financial Services, LLC
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