By: Paul A Werlin, President, Human Capital Resources, Inc.
We go through our entire lives hearing about risk. We hear people talk about an investment being “too risky,” or only wanting to make “safe” investments. Of course, there are risky behaviors like smoking or sky diving. We understand that if we engage in risky behaviors there is a higher expectation of significant or life-threatening consequences. But, when it comes to savings and investing, far too many people don’t really understand “risk,” how risk is related to potential returns and, at the same time, have unrealistic or confused expectations about their investments and financial futures. All investments have risk, and it’s true that the more risk the greater potential for return — and loss. So, let’s take at closer look at risk.
First, when it comes to saving and investing, it’s critical to understand there really are five different kinds of risk:
Market Risk
Inflation Risk
Liquidity Risk
Business Risk
Opportunity Risk
Let’s look at the basics of each of these.
1. Market risk is probably the “risk” most people think about when they invest in stocks and mutual funds. Stock prices go up and down and many times we can easily understand why- wars, natural disasters, political unrest and world events can move markets. But sometimes they seem to move for no discernible reason. Like the old saying, “a rising tide carries all ships,” so too for stocks. When the overall market drops sharply, most stocks do as well. For bonds, it’s the level of overall interest rates. If interest rates go up, the value of just about every bond will fall (but, if held to maturity, you may not care since you will get 100% of your investment back at maturity, unless the bond is impacted by other risks. See below). Since humans have engaged in business and trade, markets have gone up and down and there will always be market risk. The keys to minimizing this risk are holding for the long term and diversification. Over almost every long-term time period, a diversified portfolio of quality stocks has historically provided good returns.
2. Inflation risk is well understood by people who lived through the 1970’s and 80’s. During this time prices seemed to go up overnight on things like food and gasoline. Another way to look at inflation is to look at “buying power”. If there there’s inflation, dollars buy less. Inflation can really take a bite out of interest sensitive investments like CDs and bonds. For example, if a bond pays 4% interest, but inflation is 5%, even if you receive 100% of your original investment, you have less purchasing power than you had when you started. In effect, your net return is negative.
3. Liquidity risk is a measure of how quick and easy it is to buy and sell any investment, like supply and demand. It’s pretty easy to buy or sell 100 shares of Apple stock since there are literally millions of people and willing to buy and sell it. And, if you’re a seller, you get your money fast. But if you want to sell your house, it may take a while and it may not appeal to many buyers. Your home is not a “liquid” investment.
4. Business risk is a simple concept. Every business, not matter how large or small must make money to pay employees, make products/deliver services and remain viable. Every business has the potential to fail, even in good times. Businesses make mistakes, new and better competitors can spring up and a hundred other bad things can happen. The current pandemic has clearly demonstrated how many businesses can be hurt by unexpected events, while some have adapted and prospered. JC Penney, Nieman Marcus, Pier 1 and Hertz are just a few of the companies that went bankrupt in 2020.
5. Opportunity risk is written about often. No one has unlimited money to invest in every opportunity that comes along. Even Warren Buffet must make decisions about what to buy and own. When you commit to buying something you no longer have funds to buy something else. You can always sell your car, your stocks or even your home and buy something else with the money you get, but until you sell and get your money, you’re limited- you’ve lost the opportunity to own something else (that may have turned out to be a better investment, better house or a car more fun to drive). We’re always making choices and when it comes to investing, it’s important to understand when you make a choice, you’re eliminating others, so make the most of those choices.
This post is not intended to be a comprehensive analysis of all risks, but to help you understand that, like so many thinks in life, it’s more complicated than you might have thought. Life is full of risks as is investing. Understanding the risks will help you make more educated decisions, attain your goals and hopefully, help you sleep better at night.