When we look at the performance of the investment markets so far in 2017, something seems to be missing. We know that it’s there. We can feel it. But we just haven’t seen it in a while. Our monthly and quarterly statements look pretty good, and most of the asset classes we own are doing well. So, what’s missing? We know that risk and reward are basic principles of investing. So far this year, we’ve seen reward, but risk seems to be missing.
When most people think about risk, they are thinking about market risk—the risk that their investments will lose value. Most of us still remember the harrowing years of the financial crisis that occurred a decade ago. We saw the U.S. stock markets drop more than 50% from 2007 to 2009. It was a long, painful decline, and it was a devastating example of market risk.
But risk comes in several flavors. While market risk is the boogeyman that seems to scare folks the most, it’s hardly the only risk we face as investors. One of the main reasons that we invest is to help offset inflation risk. When the prices of milk, eggs, and other living expenses go higher, it takes more money to maintain our standard of living. This flavor of risk is particularly dangerous for retirees. When you are no longer working and are living off your savings, inflation eats away at your purchasing power. The increasing costs of health care as we age are becoming a huge risk for a lot of people. What can we do? We can invest. If we can grow our investments more than the inflation rate that eats away at our purchasing power, we can stay ahead of the game. So, we end up taking on some market risk to help offset our inflation risk.
Longevity risk is the risk that we will outlive our savings. It’s another form of risk that is particularly dangerous for retirees. Thanks to the wonders of modern medicine and improvements in living conditions, we are living longer. This means that we are spending more money and putting more stress on our savings. Longevity risk is bad enough, but when it’s combined with inflation risk, it’s a double-whammy to retirees. Again, we try to mitigate these risks by taking on market risk. If we can grow our savings by investing wisely, we can help offset some of the risk of running out of money in our later years.
There are other risks that we face when investing. Concentration risk is the flavor of risk that comes from having too many of our investment eggs in one basket. If our portfolio is heavily concentrated in one type of investment, an individual stock, a bond, or even an asset class, we risk losing money if that investment does poorly. We can reduce this risk by diversifying our portfolio across many investments, industries, and countries.
Credit risk is the risk we take when we buy a bond or other type of fixed-income investment. When we buy a bond, we are basically lending our money to a company or a government. Credit risk comes from the chance that we don’t get paid back when the bond matures. Once again, this risk can be lessened by owning a diversified portfolio of bonds, or by owning a bond fund.
We can’t avoid risk, because it is everywhere in one form or another. The key to being successful financially is to balance the types of risk. That balance is different for everyone. We accept some of one type of risk to help offset another type. We all have different goals, and we all deal with the different types of risk in different ways. It’s important to find the balance that is right for each of us.