“Crucial to virtually any investment strategy is knowing how much risk is involved when the investment methodology is put into practice. We know it’s a dark and spacious world out there, this concept of risk. So we channel “Star Trek,”—Boldly going where no man has gone before—to help you navigate the outer reaches of “investment risk.” Not only is it complicated, it’s also misunderstood—and rarely explained.
When explaining risk, the industry standard is to use terminology that assumes everyone sees the same things, interprets what they see the same way, and understands all the words that go along with it. Rarely will you sit with an advisor who will take the time to explain risk variables and in what context they might be used. Granted, those questions aren’t often asked by you. We don’t think you should have to ask. Whether you’re a fan of Mr. Spock or Captain Kirk, we just want to make sure we’re all talking about the same show.
Here’s where the confusion may rest…the many possible definitions of “risk”:
- Market risk—The inherent reality that investment markets go up and down.
- Timing risk—Being in or out, either at the right time, or, more importantly, at the wrong time.
- Purchasing power risk–Equates to inflation. When there is inflation, and that’s virtually all of the time, everything will cost more in the future than it does today
- Credit risk—Relates to investment bonds, CDs, annuities, and so forth, all fixed-income purchases, to which, basically, you are lending your money. Upon maturity, the end of a pre-determined term of the loan, the holder of your cash pays interest on that loan and returns the initial investment. The risk is whether the entity will actually be able to repay the loan or not.
- Liquidity risk—The ability to get out of an investment when you want to, hopefully, without penalty. Your home has limited liquidity; it could take quite a while to sell before you can liquidate your asset. Your 500 shares of IBM stock have instant liquidity while the stock markets are open. Your private placement natural gas limited partnership may have no liquidity until the general partner decides so.
- Maturity risk—Those fixed income investments that pay you back when you make the request. If you want to fund a special event three years from now, you want to set the maturity date appropriately. Or, if you are just investing for income, you might want to spread out maturities over a span of time to take advantage of rising interest rates. Similar to “reinvestment risk.”
- Call risk—Related to bond trading. The issuer “calls” the bond to buy it back earlier than the maturity date would normally allow. By doing this, you risk losing cash flow from the bond. Once it’s “called,” that is, the transaction is completed, the income stops.
- Reinvestment risk–Picks up where call risk leaves off. You now have your money back from the bond and may need to reinvest it. Interest rates, up or down, now impact the income you will receive from the reinvested monies.
- Transparency/disclosure risk–Linked to knowing what you really own. Is it really what you think it is? Do you know what’s in the mutual fund you own? The published data may be months old.
- Geo-political risk–Self-explanatory. Governments all over the world can do things that are real stupid, yet have significant impacts of the global investment markets. It might be financial in nature, or it might be military aggression, but we can’t always see it coming. This is an area that becomes more and more fraught with risk all the time, and we better be ready to react when it does.
- Longevity risk—Pertains to the fact that we are living longer lives. We ask, “Will I outlive my money?” Longevity can be very difficult to quantify with any degree of certainty, since no one knows what the future will bring, but you may need to ask yourself, “Have I planned for a life beyond 100 years of age?”
- Sequence of return risk—Also an aging issue focusing on what would happen if you chose to retire right as the investment markets take a steep nose dive. You would be taking money from your accounts at a rate that might not be supported by the newly reduced values of those accounts. This—and taxes—could take a big bite out of your account balance, leaving less for future income needs.
- Sequence of consumption risk—Based on how much you spend and when, and whether it was planned for or just happens. There is also the likely scenario that more will be spent in the earlier years of retirement than later on, as folks enjoy the fruits of their labors. The major exception to this centers around the inevitable increase in health care cost as you get older.
Undoubtedly, there is more to say about “risk” but…what people are really most concerned about is this: “Don’t lose my money!” And while that sounds simple, as you can see, there are many issues that need to be considered.
Knowledge is power, and we hope this list of risk issues is powerful information for you.”