Let's talk about risk

In investing it is very common to talk about “risk”. Most often, this is framed in a very basic way, as in, risk of losing money, something called investment risk. Also most often, investment risk is put in rather short term time frames such as the next 6 months or year or even few years. From prior articles, though, remember that any funds needed in that short of a time frame should have very little of this type of risk at all, because they are (or should be) likely in cash-like investments.

Risk/potential reward is a tradeoff. I say “potential” because there are no guarantees. Pertaining to investment risk, the greater the risk an investor is willing to take, the greater potential return. In the short run, this can lead to a very wide range of outcomes (standard deviation) either positive or negative. This can be thought of as volatility, both positive and negative. The longer the time frame, though, the narrower and more predictable the ranges become. This is why it makes sense for short term investments to have less risk, and with long term returns it may be appropriate to take greater risk to seek higher potential returns.

Within the investment category are subcategories. Systemic risk is total market risk due to macroeconomic, political or other factors that would affect the whole market (think 9/11, Great Recession or Covid). Systemic risk cannot be easily mitigated. Unsystematic risk is company, investment or allocation specific, and this can most commonly be mitigated through diversification.

Diversification can be achieved through indexing in funds or ETFs, or it can be done by varying your individual securities. Holding a basket of 10 tech stocks or 5 different large company ETFs may not offer significant diversification or risk mitigation. But holding an international, small cap, mid cap, large cap and commodity fund might. So might holding a concentrated portfolio of individual securities as long as they are different from each other, such as holding a health care stock, an energy stock, a utility stock and a tech stock.

Sometimes during market volatility, a client might tell us they want to reduce risk. First of all, it’s better to have that conversation during market advances (see my “The market is up” article) vs. after it is declining. What investors need to know though is that by moving to more conservative positioning, they aren’t eliminating risk, they are simply taking another kind or risk. This may or may not be preferable.

Getting more conservative would usually entail reducing stock allocation and adding bond and cash allocation. Cash is stable, and bonds are more stable than stocks.

Bonds come with interest rate risk. As we saw in 2022, as interest rates rise, bond prices decline. In fact, those who got more conservative in 2022 may have had larger losses than those that kept their original allocation. They also come with duration risk, meaning the longer the term of the bond the more susceptible it is to changes in rates. In a rising rate environment, shorter term bonds would typically hold value better than longer term bonds, and vice-versa in a falling rate environment.

We typically think of cash as a riskless asset. But cash comes with inflation risk, particularly the longer in timeframe you go. By being in cash (which is completely appropriate for your reserve or short term expenses), the returns an investor earns overtime will have a hard time keeping up with inflation. Cash invested in certificates is exposed to reinvestment risk. In a rising rate environment, short term CDs like 6 months may have higher rates than longer term CDs, as a result of something called the inverted yield curve. The temptation is to take the higher yielding short term investment, but in some cases, it may make sense to take the slightly lower yielding longer term investment. In 6 months, rates may be lower than they are today, and the CD that matures in 6months would be reinvested at a lower rate, potentially lower than the original longer term rate.

There are additional risks as well but these are the most common ones investors face. It’s important to know that there is no such thing as “no risk” as adjustments in risk are really just tradeoffs for different types of risk. The keys are to know your own tolerance for the different types of risk, to know what your own situation and financial goals require, and to separate your long term and short term investments so you can choose the appropriate risk/potential reward tradeoff for you.