Ask anyone. Most investors tend to associate risk with loss. But losing money can happen without market risk every day: Congress can raise taxes, inflation can reduce purchasing power, your spouse can beat you to the dresser in the morning.
Investment risk incorporates other risks and understanding them, along with the potential return associated with each one of them can help you determine whether your investments are appropriate for your situation.
Depending on the time frame, most would agree, I think, that stocks have historically been associated with the highest level of market risk — the potential that an investment may lose money in the short term. It’s also true that over the long term stocks have outperformed both bonds and cash investments.1 This risk/return tradeoff may influence how you allocate your investments.
The bond market, of course has its own set of risks: Credit risk, the possibility that a bond issuer could default on interest and principal payments; and interest rate risk, the chance that rising interest rates could cause a bond’s price to fall, are both examples. Rising interest rates historically have influenced the prices of bonds more directly than stocks.1 When short-term rates are on the rise, investors may sell older bonds that pay a lower rate of interest — causing their prices to fall — in favor of newly issued bonds that pay higher interest rates. On the plus side, bonds historically have exhibited less short-term volatility than stocks; but, you can see how market forces can operate.
Don’t overlook the importance of reviewing even cash investments, such as money market funds, from the vantage point of risk and return.1 Although money market funds typically experience a low level of volatility, they may be subject to inflation risk — the possibility that their returns may not keep pace with the rate of inflation, like in our current environment where money market instruments aren’t much different from cash, from a yield point of view…. Okay for emergency funds you may need within the next year.
Risk management is really all about correlation. In an ideal world, all your investments would be diversified among assets that would move up and down in varying degrees – like the pistons in an engine. Two of them are always opposite and the rest vary in degrees of correlation in their movement. Too bad the world is never so ideal; but, we try. Reducing correlation has become more difficult over the years as the markets themselves seem to have become more correlated, which is why alternative approaches, like floating-rate strategies have seemingly started to find their way into more investors’ portfolios as rates have begun to rise.
Important to understand: You really can’t diversify away market risk. If you bought every stock in the market, you’d be diversified, for sure; but, you would have only replicated market risk, not reduced it.
1 You know the speech: Past performance does not guarantee future results. Investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. The fund’s yield will vary.
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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.
The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.