13 Risks You Could Face When Investing
Risk-taking is necessary for investors, and understanding your risks is crucial to developing a sound investing strategy.
With the Presidential election just around the corner, the idea of risk seems to be top of mind. What if Trump wins? What if Clinton wins? Which party will control congress? How will the investment markets react to the outcome? What's the risk to all of us?
This is an example of the geo-political risk that exists all the time all over the world, and we all need to be aware of it no matter when we choose to invest our hard-earned dollars. It may just seem more pressing today because you can't escape all the news fixated on the election. But the reality is we've all known for a long time that an election, and all the uncertainties that come with it, was going to occur this year. So we've had plenty of time to bake that knowledge into our investing strategies and can trust that our long-term plans can hold—no matter what campaign drama takes the headlines today.
Indeed, there is always more to the story of risk than just what is top-of-mind at this moment. Crucial to implementing virtually any investment strategy is knowing how much risk is involved at any given time.
We know the universe of potential risks is dark and spacious, the final frontier. So let's channel "Star Trek"—and boldly go 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.
Here's where the confusion may rest: the many possible definitions of risk. So let's explore the following 13 variations. Understanding them is the first step to devising an appropriate investment strategy for you. To do anything else would be highly illogical.
As noted above, governments all over the world can do things that are really 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.
The inherent reality is that investment markets go up and down.
Being in or out of the market either at the right time or, more importantly, at the wrong time makes a huge impact on your portfolio.
Purchasing Power Risk
This 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.
This type of risk relates to investment bonds, certificates of deposit, annuities and 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 you.
Liquidity is 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 otherwise.
When bond trading, you risk losing cash flow from the bond. The issuer can "call" the bond to buy it back earlier than the maturity date would normally allow. Once it's "called," the transaction is completed, and the income stops.
If a bond is called, you now have your money back and may need to reinvest it. Whether interest rates are up or down at the time determines how much income you can receive from the reinvested monies.
Similar to reinvestment risk, maturity risk relates to 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.
Also known as disclosure risk, this type of risk is 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.
The fact that we are living longer lives unfortunately comes with its own risk. We must ask, "Will I outlive my money?" Longevity can be very difficult to quantify with any degree of certainty, but you may need to ask yourself, "Have I planned for a life beyond 100 years of age?"
Sequence of Return Risk
What would happen if you chose to retire right as the investment markets were to 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
How much you spend and when, and whether it was planned for or just happens, is an important consideration. It's also likely that you will spend more in the earlier years of retirement than you will later on—most folks want to indulge and enjoy the fruits of their labors especially when they first retire. The major exception to this tendency centers on the inevitable increase in health care costs 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!" While that sounds simple, as you can see, there are many issues that need to be considered. I hope this list of risks helps you clarify your investing mission and navigate your journey to live long and prosper.
Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. "Our mission is to help our clients discover, design and live the life that they want to live by matching their finances with their visions, values and goals."
About the Author
President, Pelleton Capital Management, Ltd.
Charles C. Scott, Accredited Investment Fiduciary®, has more than 30 years of experience in the financial services industry. He developed and managed an institutional sales department for Washington Mutual, and then served as the Northwest Regional Manager for MFS, America's oldest mutual fund company. Since 1993, he has been an independent adviser, focusing on providing his clients with objective, unbiased planning and investment advice. He has written for the Wall Street Journal, CFO Magazine and other publications.