Whales only get harpooned when they come to the surface, and turtles can only move forward when they stick their neck out, but investors face risk no matter what they do.
But despite the fact that investors are swimming in risk, most fail to understand it.
“When it comes to investing, risk is the most difficult concept for people to understand,” says Mark Riepe, a vice president with Ibbotson Associates, the Chicago investment research firm. “People understand dollars and cents, but risk is much tougher to grasp.”
The first thing you need to know, however, is that there is no such thing as “risk-free.” Risk, in one form or another, is unavoidable. It is a condition of every financial move, the one sure thing in investing.
Even though risk is amorphous and assumes many forms, most investors see it only in the potential to lose money. That’s why, in nervous market times like these, many people believe they can eliminate risk by protecting their principal.
They’re wrong. Those strategies simply shift and diversify the risk. That can be a good move, but it’s not risk-free.
If you turn your mattress into a piggy bank, for example, you avoid all risk of investment losses, but maximize the risk that the money’s buying power will be eaten away by inflation.
In these times when the market seems “risky,” investors should take great pains to figure out which risks they face in the management of their money, considering all financial moves in the context of the possible costs of making a mistake.
Here is a rundown on some of the risks investors face:
– Shortfall risk. No matter what your investment strategy is, this is a risk that must be considered. It is the potential for your investments to fall short of your goals, to leave you with a hole that you have no means of filling.
In short, it’s the risk that you will outlive your money.
All too often, investors worry about losing money in the stock market but are so conservative that they can’t make enough money to live out their days. Or, conversely, they invest aggressively as if the goal is to make the most money, only to suffer a big loss that swallows their nest egg.
– Market risk. Sometimes called principal risk, this is what most people consider the big one, the possibility that a market crash or correction will wipe out an investment.
But market risk should not be confused with volatility. The stock market, for instance, has been very volatile in the last decade, but it has not been particularly risky. The markets have been so rewarding in that time that almost any investment turned a profit.
– Purchasing-power risk. Also called inflation risk, this is virtually the opposite end of the spectrum from market risk. It’s the “risk of avoiding risk” that comes from being too conservative, by not allowing money to grow fast enough to keep pace with inflation.
– Interest-rate risk. This double-edged risk comes into play for people who invest in bonds, certificates of deposit and other conservative holdings.
Say, for example, a consumer invests in a certificate of deposit. When the CD matures, the consumer risks not being able to invest at the same rate in the future.
Conversely, if someone ties up money in, say, long-term bonds, they run the chance that interest rates will rise. Their locked in return, in that circumstance, might not keep pace with inflation.
– Timing risk. This has less to do with market timing– trying to get out of the market before downturns–than it does with your personal time horizon. Studies show, for example, that there has never been a 20-year period during which stocks have not made money; that means that if you have 20 years to invest, principal risk (the likelihood you will lose money) is low.
But stocks have lost money over any number of three-year periods. If your time horizon is three years, the likelihood that you could face a loss becomes much greater. The longer your time horizon, the easier it is to mitigate risk.
– Property-appreciation risk. If you invest in real estate, collectibles and other tangible assets, this is a major concern. If the real estate market crumbles or the world loses interest in, say, antique beverage containers, your investment can come up a loser and provide less profit than anticipated.
Add to these situations the potential for liquidity risk, which is a problem any time there is a high cost to selling a good or when an investment won’t sell at all.
For example, old comic books might appreciate nicely over the years, but they can’t always be cashed for maximum profits in the event of changed needs or an emergency. (Liquidity risk also takes the form of potential early withdrawal penalties or big tax bites that come with getting out of long-term investments before maturity; the lack of liquidity, coupled with those costs and the potential to need the money, should be considered before investing.)
– Credit risk. This is the risk that the company or agency that owes you money–most likely a bond issuer, insurance company but including anyone who owes you a debt–is going to fold and/or blow off its obligations.
The flip side to credit risk is prepayment risk, which involves having notes paid off early, sometimes before an investor has earned enough to pay for the commission on the deal. It’s also an adjunct to interest rate risk; not only do you face having the security paid off early, but you may not be able to reinvest at the kind of return you need.
And while all of that seems like plenty of risk, you can’t forget other forms of risk emanating from currency fluctuations to poor advice and everything in between.
Since investors have no choice but to wallow in the risk pool, experts say the best course is to accept the risks you can stomach and avoid or reduce those that make you ill. Doing this requires looking at each investment individually and examining a worst-case scenario in real dollar terms.
In addition, diversifying your types of risk trims the overall volatility of an investment portfolio. Combining market risk (stock investments) with purchasing-power risk (bonds, certificates of deposit) with property-appreciation risk (a home), an investor winds up being less vulnerable than if the entire portfolio was subject to just one type of risk.
“Sometimes taking on more risk, just in different forms, is the best way to go when the market makes you nervous,” says Walter S. Frank, chief investment officer at IBC Financial Data in Ashland, Mass. “But just because things have gone up and continue to look pretty good is no reason to believe there is no risk.”
