The Wrong Way to Reduce Your Risk in Today’s Stock Market

As expected, markets have been more volatile than normal so far this year. When this happens, investors tend to want to adjust their portfolios to “get rid of the risk.” But what does that mean?

While changes to a more aggressive portfolio may reduce equity market risk, many times we are trading one risk for another when we make those changes.

Today, let’s explore some of the different types of risk investors face in their portfolios so that we can make educated decisions when looking to reduce risk.

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1. Market or Systematic Risk. This is easy, as it is the one most investors are talking about when they say they want to reduce risk in their portfolio. Reducing your exposure to stocks can reduce the risk that a stock market decline will negatively affect your portfolio.
2. Currency Risk. Investors like to add international holdings (non-U.S.) when investing. This helps to diversify the portfolio by reducing the dependence on the performance of only the U.S. stock market. One downside to international investing can be currency risk. This is the risk that if the value of the currency exchange rate changes between the time you buy an investment and the time you sell it, your investment returns could be affected by that change — both positively or negatively.
3. Geopolitical Risk. Like currency exchange risk, international investments can be affected by unstable governments. Changes in laws or leadership can have serious consequences for investors, as we’ve seen recently with the Russian invasion of Ukraine. This is why many investors like to invest in the U.S., due to its stable structure.
4. Liquidity Risk. This is the risk that an investment may not be easily sold, like a mutual fund or ETF can be. Real estate is an example of liquidity risk. I can’t convert it to cash in two days like other investments. Small, thinly traded stocks or bonds may also lack marketability and therefore exhibit liquidity risk.

Fixed income has its own set of risks, which are often overlooked by investors when they want to switch from more aggressive portfolios. Investors all too often mistake fixed income (bonds) for safety. The reality is that while fixed income investments can be less volatile than equities, they actually have different types of risk that can affect them.

1. Inflation Risk. Rising prices have been all over the news lately. Inflation soared to 7.5% in January, the worst in over four decades. Inflation actually affects both equites and fixed income, but the effects are felt worse in fixed income.
2. Interest Rate Risk. This risk scares most fixed income investors right now. As interest rates rise, bond prices fall. Think of them as a seesaw. Since the early ’80s we have seen declining interest rates, which has been very helpful to bond investors. Now that we see that trend reversing, I would expect bonds to return very little on a real return basis for the foreseeable future.
3. Reinvestment Risk. Once a bond matures, if those funds are reinvested into another bond, they might be invested at a lower interest rate than your old bonds were, thereby reducing your income received.
4. Default or Credit Risk. Since bonds are actually debt instruments, there is a risk that the company will not be able to make the required payments.

Clearly there are an awful lot of risks that investors can face other than just the risk of volatility in the stock markets. Understanding these risks can help make you a better investor.

So, if you really want to “get rid of the risk,” what should you do? There is no true way to eliminate risk, but you can certainly reduce it. Many non-investors think “safety” means parking money in a checking and savings account and “eliminating” any type of investment risk. However, even those accounts are subject to risk. As noted above, inflation is sky high at the moment and may continue to be for some time. Inflation reduces your buying power, therefore subjecting you to “risk.”

The only way to reduce risk would be to diversify and have an established plan for different types of investing environments. Having a well-thought-out plan can go a long way in ensuring financial success when uncertainly arises.