By Thomas Rindahl, CFP
“I don’t want to take any risks.”
I get this statement frequently. It’s usually followed by something to the effect of wanting to keep it in the bank “where it is safe.” Because of this, I usually follow up that statement with the observation, “So, you prefer to lose your money slowly then.” “Huh?”
Let’s talk about “risk.”
Generally speaking, when people talk about risk, the conversation is about “market” risk. This is important to consider. As we have seen over the past several months, the stock and bond markets have experienced severe downside volatility. This can be exceptionally impactful to retirees as they start living off of their assets only to find those assets depreciated. Will the money last? Will they need to go back to work again?
Market risk is generally mitigated or reduced through diversification. Blending assets that respond differently to various economic and market conditions helps to reduce that volatility. Thanks to Modern Portfolio Theory, a whole suite of metrics has been developed to quantify this risk (alpha, beta, Sharpe ratio, Treynor ratio, Sortino ratio, etc.).
But there is more to risk than market risk.
Right now is a good example of interest rate risk. With rates rising, existing bonds are having a tough go of it. But aren’t bonds safe? Well, they are historically conservative and have offset the stock market volatility in portfolios, but with rates rising, newly issued bonds will be more attractive than that old bond sitting in your portfolio. If you can hold onto that old bond until it matures, no big deal. But if you have to sell it, then you will most likely take a haircut on it. Of course, the opposite is true too. If rates were dropping, then the market value of your old bond would improve, but if it matured and you tried to buy a new bond, you probably will get a bond paying a smaller coupon.
Which then brings up liquidity risk.
When do you need the money? If you need to sell a stock, bond, or other investment, how easily can you convert the security into cash at a reasonable price? Nobody wants to sell their assets at a fire sale nor do they want to take huge penalties for trying to get out of an asset.
Don’t forget about business risk.
So, you’re a stock picker, or maybe you have been working for XYZ blue chip company all your life and have a huge position in the company, or you have a billion dollars’ worth of options in the lasted startup. Life will be fine because that stock will set you up just fine. But then in the flash of an eye, something happens and the stock sinks and never fully recovers, or worse yet, becomes worthless. It happens. Think MCI, Enron, Bear Stearns, Lehman Brothers, or any number of .com companies. Companies can be run well or poorly. It may be mismanagement. It may be fraud. It may be that the business model was not sustainable.
All of these risks can be mitigated through proper diversification and asset allocation. You and your adviser can develop a portfolio that will take care of all these concerns so depending on your goals and objectives, the funds will provide growth or stability or income or liquidity, etc.
But I said you would lose money in the bank. What about that?
Inflation risk. We are all dealing with the effects of inflation right now. Food, gas, rent, everything is going up! While you’re getting maybe 1% on a savings account and maybe a little more on a certificate of deposit, the Fed is trying to get inflation down to around 2% from where it currently is at over 8%. Now, I am not bashing savings accounts and CDs. Those are great places to keep your emergency money. But if you have your life savings in that type of account and intend to live off of it, you are losing money!
I haven’t touched on every kind of risk out there, but you get the picture. There are a lot of variables that can affect investment. Talk to your advisor. Make sure you are making your portfolio as robust and resilient as possible!
About the author: Thomas Rindahl
Thomas Rindahl, PhD, MBA, CLU®, ChFC®, CFP®, LUTCF, BFATM, is a financial advisor in Tempe, AZ. Through comprehensive and holistic financial planning, he has helped his clients to navigate the twists and turns of life for over 20 years.
Securities offered through Securities America, Inc., Member FINRA/SIPC. Advisory services offered through PFG Advisors. TruWest Wealth Management Services, TruWest® Credit Union, Securities America, and PFG Advisors are separate entities. Securities, insurance, and advisory offered through Securities America, PFG Advisors or their affiliates are: Not NCUA insured. No credit union guarantee. Not credit union deposits or obligations. May lose value.