The path to financial reward is strewn with unavoidable risks. Investors must first understand the nature of risk in order to keep it under control in their portfolios.
Even someone who keeps his life savings in a mattress faces risk; the cash could be stolen or inflation may erode its value.
All investors face inflation risk. Other major types of risk include interest-rate, market, event, and currency.
Inflation risk refers to the tendency of currency to lose value over time. In the United States, $1 buys less than it did at the beginning of the decade. A first-class postage stamp in 2000 cost 33 cents; now it costs 41 cents to mail a Mother’s Day card. First-class letter rates will creep up to 42 cents on May 12.
And it’s not just stamps. The U.S. government says that a basket of goods that cost $100 in 1970 cost $534.39 by 2007. So, to maintain the lifestyle you have today, you will probably need to spend more money in the future. Historically, stocks have been the asset class that best outpaces inflation over long periods, and that best maintains purchasing power.
Over short periods of time, however, stocks and other asset classes can be volatile.
It is well known that stocks are typically riskier than bonds. Investors buy them anyway because of the risk/reward premium. By purchasing stocks, investors are indicating they believe that potentially higher rewards inherent in stocks outweigh the risks.
As recent market activity shows, this is not always the case. In fact, in 23 of the 82 years from 1926 through 2007, or close to 30% of the time, the S&P 500 produced negative returns.
“The bottom line is that the outperformance of stocks relative to Treasury bills is not what economists call a free lunch — there are risks involved,” says Larry Swedroe, a financial planner and author of Wise Investing Made Simple.
Swedroe agrees with S&P Chief Investment Strategist Sam Stovall that while it is a virtual certainty that risks will manifest themselves intermittently, we cannot, unfortunately, know when, or for how long, the periods of underperformance will last, nor how severe they will be.
“During periods of underperformance, investor discipline is tested,” Swedroe says. “The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon — buying high — and they observe yesterday’s losers and abandon ship — selling low. It is almost as if investors believe that they can buy yesterday’s returns, when they can only buy tomorrow’s.”
Swedroe advises long-term investors use a stay-the-course approach. While he certainly advocates being aware of market volatility, and its causes, he does not necessarily advocate making major moves in a portfolio when the market is volatile.
In many cases, the volatility comes down to event risk. Sometimes the event is geopolitical and affects the entire market; the terrorist attacks on September 11, 2001 are one example. Sometimes an event seemingly concerning only one sector spreads to others; the subprime mortgage situation provides such an example.
In the beginning, many market watchers viewed it as a problem only for financial services companies, though as it grew, it started to affect consumer discretionary companies, while the resulting credit crunch is making debt financing hard for companies in any sector.
Individual stocks can also be hurt by bad news emanating from their sector or industry. For example, when AMR Corp.’s (”AMR”) American Airlines cancelled thousands of flights earlier this month because of safety concerns, other airline stocks fell as well. That’s an example of sector-specific, or industry-specific, event risk.
The last type of event risk is specific to the company: a management change, an earnings warning, or delays in shipments.
To reduce sector-, industry-, or stock-specific event risk in your portfolio, you should consider holding a variety of names in each asset class and diversifying among different sectors.
Another type of risk is interest-rate risk, whereby a security can decline in value as a result of a rise in interest rates. Bond prices move in inverse relation to interest rates, as do the prices of real estate investment trusts (REITs), which are popular among income-oriented investors.
Currency risk comes into play for people who invest in foreign securities. When investing in foreign securities (CDs, stocks, or bonds), investors must be aware of what currency conversion rates will do to their investment. For at least the past year, the dollar has been declining against other major currencies, which improves the value of foreign holdings for U.S. investors. However, when the dollar is rising against other currencies, the opposite would hold true for the value of foreign holdings.