Risk is a fundamental aspect of the human experience. Daily activities, such as walking down a flight of stairs, are more risky to some than to others. Certainly, multiple factors go into the degree of risk one experiences. Consider that flight of stairs - wouldn’t a spritely teenager’s belief that this is a risky venture be quite different from someone who just had knee replacement surgery? Inherently, risk and one’s tolerance of it is dependent upon the situation AND the individual.
When it comes to one's investments, there are certain risks with which we are all familiar.
- Market risk is possibly the most well-known - if the market takes a downturn, so do our portfolios.
- Opportunity risk, perhaps best summarized by the phrase, “I wish I would have…” Rather than a risk we wish we would have acted upon, we must suffer the cost of inaction.
These are risks most of us would like to avoid. Of course, sometimes we do, and sometimes we don’t. But, it is one’s ability to tolerate risk that determines to what degree we are willing to take it on.
However, regardless of whether we are conservative or aggressive investors, some type of risk is unavoidable. Here are a few various types of risk that one may experience on the investor risk tolerance spectrum:
- Financial Risk: Financial risk is the risk of issuer default. A company goes south, and suddenly their various debt and equity security instruments take a turn in value. This is generally mitigated via diversification, purchasing a variety of securities from various issuers, rather than putting all of your investment future in the hands of just a few companies.
- Market Risk: This is the risk that every investor, regardless of how diversified they are, may not avoid. This is an inherent part of the economic cycle - markets expand and contract - and depending on where you’re at in terms of needing your funds, it could have either a significant negative impact, or simply be something one must ride out. One fundamental to keep in mind - the market never stays the same forever.
- Interest Rate Risk: This type of risk is going to have a greater impact on those invested heavily in bonds. The United States has not experience a rising interest rate market in a number of years, but, as I mentioned earlier, the market never stays the same. Eventually, interest rates will rise. When that happens, bond prices will conversely decrease. Because of their extended time horizon, long-term bond prices will be affected by the change in interest rates much more than bonds with shorter maturities. For stockholders if interest rates rise, common stockholders may sell. This sell-off may depress the market and leads us back to that unavoidable market risk.
- Purchasing Power Risk: Otherwise known as inflation risk, this one impacts bondholders primarily and those in banking instruments such as CD’s, money markets, and savings accounts. As inflation rises, the purchasing power of the dollar declines. Bonds are most affected by inflation because their return is a fixed amount. As inflation increases, the return on their fixed investment’s purchasing power diminishes. Common stocks have historically been a hedge against inflation because their dividends and market prices have risen faster than the rate of inflation.
The fundamental premise when it comes to risk is that there is always a degree of it. The most conservative investor may still experience interest or purchasing power risk, whereas the most aggressive may experience market risk. Given this fundamental aspect, and one’s minimal ability to control it, what is the best thing to do? Consider your tolerance level, your time horizon, and work closely with your financial professional to develop the most appropriate investment plan for you.