August 13, 2021

Financial Fundamentals Series: Understanding Risk

Dana Edwards, CFP®, CSRIC®, EA
Whether you consider yourself a conservative or aggressive investor, avoiding risk entirely is impossible.

It’s Friday the 13th, and the theme of the day is…RISK!

Risk is an unavoidable aspect of the human experience. Each of us take on little bite-sized bits of risk every day. Activities such as walking down a flight of stairs or driving a car may not seem risky, but that is only because we’ve done these things so many times, for so many years. Knowledge and experience certainly bring the risk factor down, but these acts still have inherent risk, whether we are thinking about it or not. Additionally, these daily activities are riskier to some than to others. Consider that flight of stairs – wouldn’t a spritely teenager’s belief that this is a risky activity be different from someone who just had knee replacement surgery?

Risk, and one’s tolerance of it, is dependent upon the situation AND the individual.

When it comes to one’s investments, there are certain risks with which we are all familiar. Market Risk is possibly the most well-known. That’s what we call it when our investment accounts lose value when the market has a downturn. There is also Opportunity Risk, perhaps best summarized by the phrase, “I wish I would have done X.” Both Market Risk and Opportunity Risk are familiar and easier to understand because (1) we experience them far more often, and (2) they are risks that most of us would like to avoid. Of course, sometimes we do, and sometimes we don’t. Some of us love riding the crest of the market waves and fluctuations. Others of us will do everything we can to avoid it. Our willingness to tolerate risk is what determines the degree to which we are willing to take it on.

However, regardless of whether you consider yourself a conservative or aggressive investor, avoiding risk entirely is impossible. Below we explore some of the types of risk, both very familiar and unfamiliar:

Financial Risk

Financial risk is the risk of issuer default, but specifically when a business is the issuer. Many businesses sell bonds to their shareholders. Bonds are debt instruments. They are issued by a company to generate funds that they can use now, while providing their shareholders the promise of paying that money back to them at a designated date in the future. During that time, the company will also pay those shareholders interest as a financial “thank you” for loaning them funds to put into their business operations, research and development, etc.

Financial Risk is the risk of that company that you loaned money to going south, and suddenly their various debt and equity security instruments also take a turn in value. Worst case scenario, if the company goes bankrupt, depending on what level of company debt holder you are, you may never get your money back. ☹

Financial Risk is generally mitigated by diversification, purchasing a variety of securities from many issuers, rather than putting all your investment future in the hands of only a few.

Market Risk

We touched on this one already, but it’s worth revisiting because this risk is so common. So common in fact, that there is often a belief that one can avoid it. Folks who say that they believe they can “beat the market” may be disappointed to learn that Market Risk is unavoidable. Not even diversification can mitigate it away entirely. Think COVID-19 – none of us saw that coming, and remember what it did to the markets initially? How many people do you think panicked and sold their holdings? A lot and at the worst possible time.

Market Risk is an understood and inherent part of the economic cycle, and so it should be an expected part of the ride for all investors. Markets expand and grow, and they contract and lose value in an ever-evolving cycle that, over time, generally trends upward. This is why selling when the market has a bit of a dip is such a bad idea – you lose out on all that potential gain when the market comes back around (gold star to you if you recognized that as Opportunity Risk!).

Depending on what your time horizon is and how much you rely on your investment savings to provide you current income, Market Risk could have either a significant impact, or simply be something you have to ride out. One fundamental to always remember though - the market never stays the same forever.

Interest Rate Risk

This type of risk is going to have a greater impact on those invested heavily in bonds. The United States has not experience a rising interest rate market in several years, but, as I mentioned earlier, the market never stays the same. Eventually, interest rates will rise. When that happens, bond prices will conversely decrease. Because of their extended time horizon, long-term bond prices will be affected by the change in interest rates much more than bonds with shorter maturities. For stockholders, if interest rates rise, common stockholders may sell in order to buy at the new low bond prices. This sell-off may depress the market and leads us back to that unavoidable market risk.

Purchasing Power Risk

Otherwise known as Inflation Risk primarily impacts bondholders. Essentially, as inflation rises, the purchasing power of the dollar declines. Bonds are most affected by inflation because their return is a fixed amount. As inflation increases, their return on their value or purchasing power diminishes. Common stocks have historically been a hedge against inflation because their dividends and market prices have risen faster than the rate of inflation.

Purchasing Power Risk is also a significant risk for those who are heavily invested in cash. The good ole dollar bill is definitely a safe haven from a currency perspective, and a general rule-of-thumb is to have 3-6 months non-discretionary expenses on hand in cash at all times (ideally in a bank account, not under your mattress). But for folks who have significant amounts in cash beyond that 3–6-month time horizon, with each passing day, each of those dollars will buy you less and less and less. It’s a slow, steady erosion. To illustrate, think of how much a house cost in the 1950s compared to how much it costs today. $50,000 back then would have bought you a mansion. Nowadays….yeeeah, no. The reason is because all those dollars in 1950 simply had more purchasing power than they do today. If someone had put that $50,000 under their mattress in 1950 with the hopes of using it to by a house today, they would be sorely disappointed.

When it comes to risk, there is no way to completely avoid it. It is always there in different forms and different degrees. The most conservative investor may still experience interest or purchasing power risk, whereas the most aggressive may experience market risk. Given this fundamental aspect, and one’s minimal ability to control it, what is the best thing to do?

  1. Know your Risk Tolerance Level and revisit it as your life changes.
  2. Consider your time horizon – are you going to need these dollars soon? Or are they designated for long-term goals? Ideally, you should have money set aside for both.
  3. Work closely with your financial professional to develop the most appropriate financial strategy that brings together all the aspects of your financial landscape, considers the various types of risk, and implements a dynamic and flexible plan.