Most people would agree there is only one guarantee in life besides taxes, which are voluntary, although unwillingness to ‘volunteer’ may result in twenty years at Leavenworth.
Everything else in life has a risk—even getting out of bed in the morning is a risk. So it’s amazing to me that people forget that there is risk in financial investments as well.
Investment risk is something else. We usually don’t know the risks involved or we assume the risks are small. If we know the risks, we tend to ignore or overlook them, or we don’t understand them. That’s probably the most dangerous aspect we face in our investment work.
The dictionary defines risk as, ‘possibility of a loss or injury’. When we talk about financial investing, people have different ideas about what risk is.
Risk management is THE key to investment success, because by ignoring risk when making financial decisions, you face a high probability of losing money! So we need to understand risk to make good financial decisions and improve our chances of success, especially when we’re talking about your retirement nest egg. We need to understand what factors create risk and how to control or manage those factors.
Many clients tell me that they want safety in their investments. But most do not realize that EVERY choice we have for investing has some risk attached to it. Thus, we must understand what that risk is and minimize it.
Let’s look at the risks we face as investors to see how we can reduce, control, or come close to eliminating them.
1. BUSINESS RISK
The simple rule of thumb is to keep no more than 10% in one company (stock) at any time, and no more than 20% in any one industry in the growth portion of your investments.
2. INTEREST RATE RISK
Regarding the bond market, it’s essential to understand that the price of a bond will increase or decrease in the opposite direction of interest rates. The best defense against interest rate risk is diversification.
3. CREDIT RISK
When we buy corporate bonds, we are in effect loaning our money to a corporation for a specified amount of time and at a fixed rate of return. The best defense against credit risk is diversification.
4. LIQUIDITY RISK
Liquidity refers to how easily and how quickly we can get our hands on our investment dollars should an immediate need arise. Cash is the most liquid; real estate might be the least liquid. Diversification of liquidity in investments is also best.
5. CONCENTRATION RISK
To minimize concentration risk, I recommend that no more than 10% of your growth investments be in any one company and no more than 20% should be positioned in any one industry. There is great truth to be learned from ‘don’t put all of your eggs in one basket’.
6. OPPORTUNITY COSTS
This is yet another risk that most amateur investors don’t know much about or think about because it can be complicated. Simply stated, for many investment choices we can make, there can be an opportunity cost or we give the opportunity for greater gains.
7. MARKET RISKS
Many folks equate market fluctuation with loss. It’s not always the case; fluctuating markets can go up as well as down. Here’s the point to remember: The only time we need to know the value of our investment–whether it is shares of stock or our home—is when we want to sell it!
8. INFLATION RISK
Most people would be surprised, I think, to learn that inflation is the greatest risk we face over time. All of the other risks we’ve talked about can be managed, controlled, reduced, or almost eliminated using some straightforward strategies and some very simple tools.
Your financial plans for retirement must take into account—and compensate for—the virtual certainty of inflation over the next twenty to thirty years. One of the reasons retirement investment plans should include variable assets such as stocks and real estate is to overcome inflation risk.
How Can We Reduce Investment Risks?
Now that we know about the types of investment risks, how can we reduce or minimize them in our own financial plans for retirement?
The common thread in reducing or protecting ourselves from risk is diversification, otherwise known as not having all of our eggs in one basket.
But we’re really talking about something a bit different than diversification. The term serious investors use is ‘asset allocation’.
Asset allocation refers to a mix of cash, stocks, and bonds. There is tremendous theoretical and empirical evidence suggesting that how we allocate our investable assets is one of the most important decisions we can make.
There is no guarantee that asset allocation or diversification will enhance overall returns, outperform a non-diversified portfolio, nor ensure a profit or protect against a loss.
Hopefully you see now that there is no ONE investment that can protect you against all forms of risk. As in everything else in life, risk is always present.
Need additional guidance? Contact us for more information on managing investment risk today.