There are many forms of risk associated with financial assets. Even those instruments, like CDs and money market funds, carry one or more forms of risk although many investors are unaware of these risks. In fact, it is almost impossible to avoid all forms of risk in the marketplace as an attempt to eliminate one form of risk almost always gives rise to another real or perhaps hidden level of risk.
While risk is unavoidable, recognizing those risks that may prey on your financial assets is crucial to long-term portfolio success or failure.
In Chapter 1 of my book, The Physician’s Guide to Avoiding Financial Blunders, I define several of the various types of risk investors face. I was referring to the 10 most common financial planning mistakes I have seen in my 42 years as a financial advisor, and I stated in mistake #3, “You’re Afraid to Take Risks, So You Risk It All.” Let me summarize those risks to better help you recognize them as they affect your lifetime of accumulated investments.
Inflation risk
Most people understand this common form of risk as it affects, for example, fixed income assets. It is closely related to “purchasing power risk.” We all know a dollar 10 years from now is not worth as much as a dollar today due to the silent, insidious devaluation caused by inflation. A cardiologist retiring 24 years ago on a $50,000 fixed pension can buy today only a fraction of what he could buy then.
A handy tool to measure the effect of inflation is the Rule of 72. It can be used, in fact, to measure both the doubling and the halving of an asset or income value given both a specific rate of inflation and a certain time period. As an example, to know how long it would take for money to double at 3% annual compounded inflation, simply divide the constant 72 by 3%, and the answer is 24 years. Conversely, our cardiologist would find his pension halved in purchasing power after 24 years at a 3% annual inflation rate.
A supposedly “safe” corporate or municipal bond is affected by inflation in two ways. First, the semi-annual interest payments buy less each year as inflation eats away at their purchasing power, and, second, the purchasing power, or value, of the bond principal itself at maturity is severely reduced due to annual inflation depletion.
Although CDs and savings accounts and money market accounts are deemed “safe” by investors fleeing stocks and other equity investments, the products are rife with inflation (and tax risk). A CD yielding 2% loses 1% a year in purchasing power in a 3% inflation environment and is further reduced by federal, state and local taxes. Hardly a safe investment as the risk trade-off to get a guarantee of principal can be costly.
Investors can mitigate fixed income inflation risk by buying inflation bonds, such as U.S. Treasury Inflation Bonds, commonly referred to as Treasury Inflation-Protected Securities or TIPS, either directly from the U.S. Treasury or in mutual funds or exchange-traded funds. Also, over the long run, the history of stocks is that they ordinarily outpace inflation, but there is no guarantee that will happen.
Interest rate risk
Generally associated with bonds, the rule of thumb to describe interest rate risk is that the price of a bond will fall as interest rates rise, but will rise/rally when interest rates fall. We are in fact witnessing this today as the U.S. Federal Reserve Bank begins the process of unwinding its financial crutch to the U.S. economy by raising short-term interest rates. As such, bond prices have decreased and will continue to do so as long as interest rates increase. The extent of the rise or fall in bond prices as interest rates change is measured statistically by something called duration. Simply stated, duration is a function of maturities in a bond (portfolio). The longer the maturities, the longer the duration and the greater the impact of rising or falling rates.
For example, a duration of 4 years implies a decrease of 4% in bond prices if interest rates increase by 1%, or a rally of 4% if rates fall by the same percent. Therefore, in a period of rising rates, like now, the longer the duration of a bond portfolio, the greater the risk associated with those bonds. Therefore, a shorter duration would be called for.
Market risk
This is the most commonly understood risk of the equity markets. It can include the risk of a sector of the market or the market as a whole. If you own an energy stock, even a good one in terms of its fundamental value, you have seen its value decline as the price of oil has plunged during the last year or so. As a further example, when stocks fell in 2008 and 2009, if you owned even the best portfolio of common stocks, you lost considerable value temporarily as the Standard & Poor’s 500 index at one point in 2008 lost more than 54% of its value. Investors had no place to hide. Diversification within a portfolio can help spread market risk though it does not eliminate it entirely. Allocating your portfolio to some fixed income can also reduce equity market risk though doing so may add interest rate and inflation risk.
Specific risk
Often referred to as “business risk,” this is the risk you take with each specific equity, fixed income or other asset you own, and the success or failure of that particular asset. For example, you own Apple stock. You have seen your stock rise and fall, sometime precipitously, based on the outlook and performance of Apple’s financial fundamentals, such as earnings, dividends, etc. For the most part, you cannot avoid specific risk when owning specific assets. Bonds, too, have specific risk based on the real and perceived ability of the entity, such as a business, municipality, etc., to make its promised interest payments. Witness the dramatic decline of Puerto Rico bonds recently.
Economic risk
Economies of all countries experience downturns and those can and do affect large companies but have their most damaging effects on smaller, highly leveraged ones. Junk bonds, for example, take it on the chin in market slowdowns as the default rate among such bonds climbs. We are seeing this even today as the energy sector plummets with oil supply outpacing oil demand. The bottom line is economic risk leads to market risk in most cases. Not all sectors of the economy are affected in the same way during economic downturns. As an example, when people’s pocketbooks are feeling ill at ease due to an economic slowdown, they may stop buying expensive products (hurts those industries), substituting less expensive alternatives (helps those industries).
In the final analysis, risk in financial instruments is everywhere. The above are simply examples of the most common risks investors face, though other risks, such as tax risk, do exist. As an investor, know these risks and how they affect your portfolio and develop a plan to avoid and/or diminish them. If you feel the need for outside, unemotional, objective advice, find a competent, experienced financial advisor or wealth management specialist to assist you.
- Reference:
- Rudzinski KW. The Physician’s Guide to Avoiding Financial Blunders. Thorofare, N.J., SLACK Incorporated; 2009.
- For more information:
- Kenneth W. Rudzinski, CFP, CLU, ChFC, CRPC, CASL, CAP, is a registered representative of Lincoln Financial Advisors Corp. and a partner in the firm, Heritage Financial Consultants LLC. Securities and advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Lincoln Financial Advisors does not provide legal or tax advice. The author is unable to communicate within the comment section for this article. Any communication should be through the author’s email. CRN-1377960-122215. Rudzinski can be reached at kenneth.rudzinski@lfg.com.
Disclosure: Rudzinski reports no relevant financial disclosures.
