Understanding Investment Risks

The following is an excerpt from Personal Investing: The Missing Manual.

You can't avoid risk no matter how you invest your money. You worry that your nest egg will spoil from stock price gyrations or mayhem in the markets. At the same time, you know inflation is picking away at your boiled nest egg every moment. Some risks decrease over time, while others get worse. Here's a quick review of the different types of investment risk and how you can manage them:

• Inflation risk. Chapter 1 showed just how dangerous inflation (the steady increase in prices) can be. It's the one investment risk that gets worse with time. The higher returns of owning stocks long-term are the sure antidote to inflation risk.

• Economic risk. This is the risk of losing money in investments because the economy tanks. The economy tends to cycle up and down every 5 years or so. The down cycle, known as a recession, can last from a few months to, occasionally, a few years. As with inflation, owning stocks for longer than the typical economic cycle helps overcome economic risk. You can also avoid economic risk by keeping near-term spending money in safer investments like short-term bonds or a savings account.

• Market risk. Sometimes, perfectly good investments go down in value just because the market as a whole goes down. And sometimes, mediocre investments go up because the overall market goes up. The key to managing market risk is researching the investments you buy and sticking to your plan as long as those investments are still fundamentally sound.

• Equity risk. Many investors are afraid of losing money on a bad investment, which is called equity risk. True, companies can go under, taking your investment with them. But equity risk is easy to manage by diversifying your portfolio, that is, by buying several different investments to dilute the effect of one underachiever.

• Holding period risk. This is the risk that you have to sell an investment when its price has fallen. It's a good idea to keep some money in short-term investments so you don't have to sell long-term investments when their values are down.

• Reinvestment risk. When you invest in bonds, bills, or even certificates of deposit and hold them until they mature, you face reinvestment risk, the risk that interest rates are lower when your fixed-income investment matures and that you have to reinvest your money in a new investment with a lower interest rate. Unfortunately, reinvestment risk is a fact of life with any kind of fixed-income investment you hold to maturity.

• Interest rate risk. If you buy a bond and sell it before it matures, you face interest rate risk, the risk that the bond price drops because interest rates rise.

• Currency risk. If you invest in foreign stocks or bonds, currency risk comes into play. If the dollar falls compared to your investment's currency, your investment loses value. Currency exchange rates work in your favor when the dollar is strong compared to other currencies.

Tip: When your portfolio grows large enough or you're well ahead of your plan, you may yearn to gamble on higher-risk investments, such as micro-company stocks or high-yield bonds. As a rule of thumb, the average investor shouldn't invest more than 10% in high-risk investments.

Comments

[Eugene Krabs]

Thanks for sharing this article. Every investment involves risk of some kind, even super conservative ones that are suppose to be less risky. For example, one may be trading market risk for inflation risk. And yet, not everyone is fully aware of that.

[Old Limey]

Looking back over my adult life inflation has not been a problem. Obviously $1 back in 1958 when we came to America doesn't buy what it does today but that has to be offset by the fact that wages and home values increased greatly. My starting salary of $173/week, at age 26 in 1960 had risen to $1,374/week when I retired in 1992, at age 58.
The home that we bought for $26,950 in 1963 (with the addition of another $17,000 in 1977 when we traded up) is now appraised at $1.1M.
The bottom line is that the quality of our life has improved dramatically from 1958 to 2010, regardless of inflation. This is not true however for countries that experienced hyperinflation where their currency became worthless (Zimbabwe being the most recent).

As for the argument that one has to be primarily in equities if one is to have a good retirement, take a look at these two Vanguard funds since the start of my database which is 9/1/1988.
VFINX - Vanguard S&P500 fund - Annual compound rate of return=8.84%
VUSTX - Vanguard LT Treasury fund - Annual compound rate of return=9.05%
The equity fund had 3 times the volatility and 3 times the worst drawdown of the treasury bond fund (-55.26% versus -17.37%).
That shoots down the widely held notion that you have to be in equities, at least over the last 22 years.

One of the recent very negative developments has been that the stockmarket has become greatly manipulated by giant Wall St. investment banks. This has not happened with the far larger Bond market.

Take this worrisome year of 2010 for example.
The NYSE stock index has dropped -7.23%.
My Muni Bond fund has gained +10.3%.
My All asset classes bond fund has gained +10.49%
My Mortgage backed securities bond fund has gained +7.43%
My Total return bond fund has gained +8.45%.

So much for conventional wisdom - it's very often a joke.

[The Extra Money Blog]

no risk - no (or low) reward

i cannot agree more than 10% of the p-folio should be in speculation. this not only gives a chance for a tremendous upside to the folio - but speculation can be real fun if executed in a controlled manner (i.e. 10%)

[Old Limey]

Regarding the previous post I would add that there are occasionally times when it can be worthwhile to put your whole portfolio into a single asset class. Greenspan's "Irrational Exuberance" period was one such time. The Internet Bubble started an unsustainable rise in many of the companies in the Nasdaq 100 index.

That index went from a low of 1283 on 10/20/98 up to a high of 4704 on 3/27/00 tripling in the space of 17 months and then started dropping as fast as it went up and by 9/21/01 it was back down to 1127. That's a text-book speculative bubble.

I rode it up using about five hi-tech funds. I didn't capture it all of course - you never do. I was late getting in - you always are - and about a week late getting out - you always are, but I was able to obtain a gain of 173% on my portfolio during the same period that the Nasdaq 100 tripled and then gave it all back. During that little episode I lost $350,000 in four market days as I went to cash, but ended up a multi-millionaire.

I became quite conservative after that and continued to do well timing junk bond funds using exponential moving averages, then in late 2007 I became even more conservative and that's where I am today, 100% in CDs and Bonds with nothing in the stockmarket.

[Money Reasons]

It kind of feels like whatever we do, we face some type of money degradation risk.

I guess we should try to take a balanced approach with our investment portfolio. I know that during this past "Great Recession", my bond funds did the best... I wish I had a more evenly balance portfolio at that time. Perhaps I learned my lesson and will do so for the next recession (unless a double dip happens).

[Old Limey]

GDP Numbers
===========

.................2008..................|..................2009.....................|...............2010......................|
-0.7 ... +0.6 ... -4.0 ... -6.8 |.. -4.9 ... -0.7 ... +1.6 ... +5.0 |.. +3.7 ... +1.6
.................2008..................|..................2009.....................|...............2010......................|

At the end of 2009 the GDP numbers really looked like we were coming out of the recession very well indeed. Then this year the 1st. quarter dropped considerably from the prior quarter and today the 2nd. quarter results dropped again to less than half the 1st. quarter's results. Even though the recession is technically over we are now seeing results that appear like we are sinking right back into recession again, possibly even by the time the 4th. quarter results are out which will be late February 2011.
Possibly the economic stimulus programs such as "Cash for Clunkers", "First time homebuyer rebates" etc. ending may have a lot to do with it. Also if the Bush tax cuts go away at the end of this year that would also seriously jeopardize the recovery. This is one of those times that I am happy to be comfortably retired and in the slow lane. We had several recessions during my working career in missiles and aerospace but then we had an ongoing stimulus program the whole time - it was called "The Cold War".

[Mark]

@Old Limey: If these are Year-on-year numbers, we need to consider that we are comparing with 12 months earlier. Q4 2009 looked really good, only because Q4 2008 had been so bad. And Q2 2010 isn't that great, but Q2 2009 wasn't that bad. Refering back 2 years instead of 1 year:
Q1-07 to Q1-09: -0.7 - 4.9 = -5.6
Q2-07 to Q2-09: +0.6 - 0.7 = -0.1
Q3-07 to Q3-09: -4.0 + 1.6 = -2.4
Q4-07 to Q4-09: -6.8 + 5.0 = -1.8
Q1-08 to Q1-10: -4.9 + 3.7 = -1.2
Q2-08 to Q2-10: -0.7 + 1.6 = +0.9
Q3-08 to Q3-10: +1.6 +/- ??? = ???

In other words, Q2 2010 was the first time for a long time that GDP was higher than the number two years earlier. Even if Q3 is slightly negative (which will be a great headline for the double-dippers), the two-year comparison will show a continued improvement.

[Old Limey]

Mark:
If you have the time you should go to Youtube and watch "The most important video you will ever see". It is in 8 parts and covers the whole topic of growth and it explains why the constant growth of anything is actually unsustainable. The author is a professor at the University of Colorado.
Unfortunately most modern societies are predicated on continuous growth and this is why the world's problems seem to be getting totally out of hand.

[Mark]

Old limey - I will take a look at the videos this evening. I agree with you that our assumption of continuous growth is a fallacy.

There are studies of animal population growth which show how the populations often grow nicely (with a few hiccups along the way), and then ultimately crash catastrophically. And many businesses seem to follow the same trajectory!

My comments on the GDP numbers were not intended to dispute that, just to take a slightly different perspective on the numbers because I am very aware that any comparison depends on the baseline. Q4 2009 and Q1 2010 were bound to look good only because their year-earlier baselines were so dismal.

[Old Limey]

Mark:
I watched all 8 videos and came away from them with a much greater understanding of why the earth (which is a closed system) cannot continue to add another billion human beings every 12 years. As the professor showed in one of his charts there are two choices. Either the human race takes steps to preserve the equilibrium between human being and their consumption of the earth's resources or nature will do it for us. Nature's way is far more unpleasant.
The good thing however for the USA is that being the richest country on the planet and one with the largest group of very smart people we should be able to get our act together. It's the countries with far less arable land, limited natural resources, and a low level of literacy and education that will be the first to go under, i.e. Africa first, India, Pakistan, and Bangladesh, second. China has already showed they know how to limit the birthrate when they need to.

I see looming problems with an economy predicated on growth. How about an economy where you have about the same number of people leaving the workforce every year as are entering it and an economy where Wall Street wouldn't have a problem with a company that is not growing, not shrinking, but just making a nice steady profit year after year. In order to achieve that we need a population that stays constant and where a married couple just replace themselves rather than having lots of kids. We also have to have very tight borders or we will find ourselves inundated by illegal immigrants. We also have to reduce the numbers of legal immigrants (of which I am one). The US population has more than doubled since I arrived.

I have always thought that one of the best physical states is EQUILIBRIUM, it's far better than rampant growth or severe decline, unfortunately it's not a popular concept.

[Julia]

There is also another type of risk that is country risk, which our country Pakistan is facing now a days.