Most individuals seem perplexed about their investments when they discuss the notion of risk. Not knowing how to respond, many investors seem to relate to risk on an emotional level. Many financial advisors try to express risk to clients in terms of acceptable levels of loss in percentage terms, while others try to measure risk as the probability of failure to meet a stated goal, such as not outliving your financial assets.
There is no “free lunch” because every asset class entails at least some degree of risk. Financial advisors are tasked with the allocation of investment funds across various asset classes to tailor an investment portfolio that meets a client’s personal risk tolerance and investment time horizon. The construction of investment portfolios through the use of asset allocation models is a process in which asset classes, such as stocks and bonds, are configured so as to achieve a portfolio which is efficient. Efficient means that the mix of asset and sub-asset classes will provide risk-adjusted returns commensurate with the level of risk assumed. The investment objective is not to take on risk unless the risk is efficiently rewarded. Inefficient means taking on risk that is not adequately compensated.
To invest is to take on risk. The purpose of investing in the securities markets is to take risk and earn a positive return. An investor, however, can take on risk and realize a negative return. The challenge is to manage these risks, that is, the upside and the downside risks of investing. Given that the future is unknowable, the investment challenge is to maximize the probability of positive gains and minimize the probability of negative gains. Below is an overview of some of the asset classes and the risks investors will face investing in 2015.
Cash and Short Term Instruments
Inflation Risk: The risk associated with investments in cash is from the fact that returns may not keep up with inflation over time. Investors who are holding too much cash do not earn enough to preserve the purchasing power. Taxes can further erode the purchasing power of cash balances. The longer the holding period, the greater should be the concern.
Bonds
Interest-Rate Risk: Interest-rate risk is the chance that interest rates will increase, thereby pushing down the prices of bonds with lower coupon rates. The longer the duration of a bond portfolio, the more vulnerable it will be to interest-rate increases. Investors can reduce interest-rate risk by holding individual bonds until maturity, but it may be difficult for smaller investors to establish diversified portfolios comprised of individual bonds.
Credit Risk: Credit risk is the probability of a bond issuer to fail to pay scheduled interest and principal payments, known as a bond default. To reduce this risk, bond investors improve their position in the event of a default through investments in bonds from the same issuer secured by company assets, in exchange bonds with lower yields.
Inflation Risk: Similar to cash investments, investors earning a fixed coupon on bond investments will see a decline in their inflation-adjusted returns, price inflation increases. Floating-rate investments which provide an inflation adjustment to yields as inflation increases can reduce inflation risk for investors.
Reinvestment Risk: A bond investor that reinvests interest and principal payments at yields that are lower than the original yield-to-maturity face reinvestment risk. When overall market interest rates decline the risk increases as bond issuers are able to refinance obligations at lower interest costs. Bond investors are adversely affected when funds are received at a time when reinvestment interest rates are lower. Bonds with call protection reduce reinvestment risk through provisions that guarantee against prepayment of principal for a specified period.
Foreign Bonds
Currency Risk: Foreign bond investors face all of the risks outlined above, and they may also face a few additional risk factors. One of the most notable is currency risk–the chance that the currency in which the bond is denominated falls relative to the U.S. Dollar, thereby reducing investment returns from the bond over the holding period.
Geopolitical Risk: Foreign bond investor may also have bond losses due to geopolitical risks in the country in which an issuer is domiciled. Even though investors in such bonds don’t expect a default to be imminent, investors may demand a higher returns from these bonds to compensate for the risk, thereby driving down bond prices.
U.S. Stocks
Valuation Risk: Valuation risk can apply to purchasers of all assets, and means simply that by overpaying for an asset, the investor will earn an inadequate return for the anticipated holding period. Valuation risk can be a key risk for equity investors for a given investment time horizon.
Systemic Risk: This is the risk that the economy at large could turn down, affecting business fundamentals across industries and companies. Companies that operate in economically sensitive businesses, such as manufacturing, basic materials, and energy firms, tend to be particularly sensitive to the strength and direction of the economy. Conversely, companies that sell products that people need no matter what, such as makers of toothpaste and pharmaceuticals, tend to be less sensitive to the strength of the overall economy.
Liquidity Risk: This risk exposure means that there’s not a ready market for a given asset, so investors may not be able to sell a security because the market is thinly traded. Liquidity risk is most prevalent for micro and small cap stocks.
Foreign Stocks
Currency Risk: As with foreign bonds, this is the risk that currency losses will reduce any gains, or magnify any losses, associated with the underlying investments. While foreign-currency fluctuations can have a meaningful impact on the returns that U.S. investors earn by investing in foreign bonds, currency fluctuations generally play a smaller, but still significant, role in foreign stock returns.
Geopolitical Risk: Geopolitical risk can take a toll on foreign equities, just as it can with bonds, as investors will tend to sell securities from countries where there’s military action or economic or political unrest.
Economic Risk: Commodities-tracking investments are often put forth as good investments, as hedges against inflation, because commodities prices are often rising when consumers are paying higher prices for food and energy. However, when economic growth and consumption are slow, commodities prices can drop precipitously resulting is substantial losses over a short period of time.
So what have we learned about the risks that investors face in 2015? It has taught us the true value of a financial advisor who can provide direction about how investment and financial products work and whether the risks are properly managed through an asset allocation that is suitable based on a client’s investment objectives and risk tolerance.
