In investing, just as in life, risk is everywhere. Because the stock market is what the media follow so closely, you might have come to associate risk solely with the fluctuations in the price of equities.
But, risk is at the core of all investing. One way of defining “risk” is the possibility that the return you receive on any investment will turn out to be different than what you expected. Most of the focus, of course, is on lower than anticipated returns. Those are what make investing so scary to many.
No Right or Wrong Answers in Assessing Risk
That rate of return can be affected by many factors. And those possibilities will determine what options you choose for your 401(k). Now you have the option of using an advisor, the two of you can assess the pros and cons of each option. There are no wrong or right answers but an advisor will help you understand the risks and possible rewards of each. What ultimately matters is how much risk you should tolerate. Each person has a unique view of what is enough and what is too much. This measuring stick comes from their very unique life experiences. The really good advisor will coach the client to what risk is appropriate given the client age, income and other financial data. Then educate the client on the different kinds of risk. Here are a few to ponder. How each of these truly effect you will vary greatly!
This is the only one you hear about day in and day out. Market risk refers to the possibility that you will experience losses in your investment value. It is important to remember that the various market places are auctions. Because of this the ups and downs are driven by the perceptions of the bidders. This is a “systemic risk”. Diversification itself cannot prevent the losses. But your portfolio might be configured with non-correlated assets to potentially minimize the effects of the ups and downs.
Whether it’s a bond or a share of stock in a fund there is “business” or “unsystematic” risk associated with it. In the worst case scenario, the company could go bankrupt. That could be because of changing customer tastes, new technology, an upstart competitor, or litigation. Diversification helps cushion those kinds of losses. One way to diversify is through mutual funds. Most company retirement plans use funds.
It is a myth that bonds are “safe” investments. Those issuing the bond could default. Default happens when they stop making interest payments and can’t repay the amount you have lent them. In investing the rate of return is correlated to relative level of risk. The corporate bond usually has a higher rate than a U.S. Treasury bond.
Taxability Risk with Municipal Bonds
That advantage of municipal bonds is that they are frequently exempt from federal and/or state tax. For that they usually have a lower rate of interest than taxable investments. However, there is the risk that the rules could change mid-course and your bonds would be taxable. For example, the legislature could impose a tax on your bonds. That would lower your eventual rate of return. There is no additional tax advantage for a tax deferred retirement account so municipals would not likely be seen in your retirement plan.
Call Risk (Triggers Reinvestment Risk)
With bonds, there is the possibility that the issuer will “call,” that is, redeem the debt security before its maturity date. That can happen when interest rates are falling. In that environment, companies attempt to save money by issuing bonds with lower interest rates. That means you will have to search for an investment which provides the same return with the same level of risk. That might not be possible. When interest rates decline, the investor is usually forced to take on more risk in order to replace the same income stream. This is a form of reinvestment risk.
Inflationary risk is also known as purchasing power risk. Essentially it is the possibility that the value of an asset or flow of income will be eroded. How to manage this risk? The way is through choosing investments, such as stock funds which have a possibility of growth. That positions your portfolio to stay ahead of inflation over the long term.
Liquidity risk is associated with assets which cannot be sold quickly when funds are needed. The classic example is real estate. Liquid assets range from blue chip stocks to government securities.
Because the U.S. has been more stable than many other nations, you might not anticipate what is known as political risk. That is possible when the government or society “changes the rules.”
However, you should also keep in mind that the U.S. Congress has the power to change laws affecting securities. That is specifically known as legislative risk.
In addition, society could pressure government to ban a product or service. If you own stock in companies in those sectors you could experience loss. That is social risk.
Interest Rate Risk
The bottom line on bonds is this: When interest rates rise their market value goes down. That doesn’t affect you until you want to sell them. In the marketplace the value of your bonds will erode if the interest rates rise. That is because new issues of bonds will have a higher interest rate and be more attractive to a bidder.
Currency/Exchange Rate Risk
Currency/exchange rate risk occurs when the price of one currency changes in relation to another. Suppose you have invested in a public company in Germany. The fluctuations in the currency in which that investment is denominated compared to the U.S. dollar could negatively impact the value of that security you own.
Risk Can Be Managed
Yes, risk is at the core of investing. But it can be managed. A good financial advisor will educate you on risks and help you feel comfortable accepting the appropriate amount of risk. As an example a 30-year-old could likely completely avoid interest rate risk but take on some market risk. While an 80-year-old would likely accept some interest rate risk but be averse to too much market risk. Risk lives everywhere, understand it and risk can actually be your friend!
Company Retirement Plan Self Directed Brokerage Account
Whether you have a dollar or a million dollars in your retirement account, you’ll be able to explore the value of a real advisor. Simply visit the Self Directed Brokerage Account advisor contact site.
To learn more about Rick Willoughby, view his Paladin Registry research report.
Other posts from Rick Willoughby
The Bureau of Economic Analysis recently announced personal income is up 2.7 percent in the past year. Spending...
If you’ve been watching financial news lately, you may have heard discussion about the Federal Reserve (Fed) raising...
Imagine a farmer hitching his horse to plow a large field. The horse likely starts off strongly, at...