Is Risk Lurking in Your Portfolio?
“Ya gotta spend money to make money.”
“The greater the risk, the greater the reward.”
“No pain, no gain.”
No matter where we look or what we read, we are reminded that growth always requires some level of risk. It’s especially true when it comes to growing our money; we know that investing is an essential tool for financial growth, but it comes with inherent risk.
It even says so in the fine print. Most investment-related marketing materials contain a sentence phrased something like this: “Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values…”
If we want to achieve growth, we must invest. And if we want to invest, we must be willing to expose ourselves to some level of risk. The trick is to find the right balance to maximize growth and seek to minimize your client’s exposure to unnecessary risk.
The first step is to understand what types of risks exist. The following are some of the main types of investment risk and how they might impact an investor’s portfolio.
Markets often react to domestic and global events, both positively and negatively – and take investors along for the ride. Sometimes known as “systematic” risk, market risk is always present in any investment; it can be reduced through strategies such as asset allocation, but it can never be predicted or avoided entirely.
Market risk impacts every type of investment, and includes three main sub-types:
Sub-type: Equity Risk
Applies to: Stocks
When buying a stock, there is a chance that its value could drop due to factors such as geo-political turmoil, economic downturns, and national or global crises. The risk lies in the possibility that the price of a stock may drop – leaving the investor with a loss when they sell.
Sub-type: Interest Rate Risk
Applies to: Debt instruments such as bonds
Interest rates and bond market values move conversely: When one goes up, the other goes down. When investors buy bonds in a low interest rate environment, they take on the risk that interest rates will rise in the future – and the value of their bonds (and the subsequent income from those bonds) will decrease. Typically, the longer the term of the bond, the higher the interest rate risk.
Sub-type: Currency Risk
Applies to: Foreign investments
Also known as exchange rate risk, currency risk is related to possible losses in foreign investments as a result of shifting exchange rates. For example, say Joe Smith purchases a $1,000 bond from a Canadian company for $1,000 U.S. dollars. The bond has a 5% coupon, so it pays $50 in Canadian money. At the time of the purchase, the U.S.-Canadian exchange rate is 1:1, so the American value of the bond is also $50. A year from now, exchange rates have shifted to 1:0.75, and the income is now worth $37.50 in American dollars.
Concentration risk exists when an investor puts all their eggs in one basket, investing in either one investment type (such as stocks) or a singular investment (like a specific company). For example, when purchasing a company’s stock, that stock may fall in value due to bad management decisions, industry-wide events, or decreasing demand for the company’s goods or services.
Sometimes called “purchasing power” risk, inflation risk is the potential for an investment’s value to decrease due to inflation. For example, say an investor purchases a bond. While the investor receives fixed income throughout the life of the bond, over time those same dollars don’t stretch quite as far as they did originally due to inflation. Investments that cannot keep up with inflation rates will remain stagnant instead of providing growth.
Liquidity risk is the possibility that you won’t be able to sell an asset when you need to – or that you’ll have to sell at a significant loss. A common example of liquidity risk: You buy a house, which you plan to live in for at least 10 years. You assume that you’ll be able to sell the house at the end of that period, but you can’t predict what buyers will want, housing marketing prices, or mortgage interest rates in a decade. There is a risk that you won’t be able to sell the house for as much as you originally planned.
The potential for each type of risk can ebb and flow due to economic factors, global events, and simply the passage of time. While investors – and advisors – can never completely eliminate risk, there are ways to mitigate it. Diversification and proper asset allocation seek to provide your clients with the growth they want and help reduce the risk they don’t need.
1087103 – FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR USE WITH CLIENTS OR THE PUBLIC. This content is provided for informational purposes only. It is not intended to be used as the sole basis for financial decisions, or should it be construed as advice designed to meet the particular needs of an individual’s situation. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values.