Risk is a fact of life, and it is a part of everything we do. Think about this: driving down the street is a huge risk that most people willingly take every single day. We indulge in foods that often pose a risk to our long-term health and wellness. We even carry around our valuable smartphones in our pocket as if they weren’t made entirely out of glass and wouldn’t shatter the moment they fell to the ground. If that last one made you cringe, you aren’t alone!
Yes, risk is present in all parts of our life — but nowhere is risk presented as boldly as it is in financial planning.
Recently, the low interest rate environment has forced many to invest in riskier assets than they normally would. The stock market has shown us it can drop over 15% at any point in time. Clearly, there’s more to risk than the decrease in value of securities. But, what are the different types of investment risk and how do you know if you are taking the appropriate amount in the current environment? My friend, that’s where we come in.
What’s right for me?
Everyone has an appetite for risk — the level of risk, though, depends entirely on the person and their goals. Some feel a sense of freedom with their investment portfolio that encourages major risk-taking, while others would benefit more from the security of a warm financial blanket. When evaluating your relative comfort with financial risk, it’s crucial to take a step back and look at your situation in its entirety. Forget about the nuances and look at the big picture — where have you come from, and where would you like to go? Are you inspired by uncertain possibilities, or to do benefit from a clear and tangible roadmap? Bring some self-inquiry into the process by asking yourself how risk factors into your everyday comfort: do you trust in unseen processes, or you do find comfort through micromanagement? What is the level of confidence you have in your financial team? Do you have a Type-A personality, or a Type-B personality?
The answers to these questions offer invaluable insight into the best financial scenario for you, as an individual with hopes and dreams as well as day-to-day concerns and humanistic fears. What is right for someone else is likely not what is right for you — how could it be, anyways? — So know yourself and be able to voice your needs with purpose, confidence and educated clarity.
You may have also heard this called ‘systemic risk.’ Market risk is the possibility of an asset’s performance as it correlates to the overall performance of the financial market. It’s the risk involved in participating in the financial market and all of its inherent, external factors. Recessions, interest rates and natural disasters are all examples of market risk. Market risk cannot be reduced by the panacea of diversifying your investment portfolio, however, with a skilled team it can be hedged against.
Interest Rate Risk
This is the likelihood that the price of an investment will decrease as the value of interest rates increase. This effects bonds more than it does stocks, so this is something you’ll want to pay attention to if you are a bondholder. A diversified portfolio can greatly reduce the possibility of a decline — but that is often easier said than done.
Another risk associated with bonds and bond funds, credit risk is the borrower’s ability to repay its debt once a bond matures. A borrower may default on a debt for many reasons, such as disrupted cash flow. Debt instruments are given credit ratings by agencies, but credit risk and the rating are often inversely related. The higher the rating, the lower the risk… usually. Sometimes credit rating agencies can get it wrong, so it’s always important to complete your own due diligence, or consult your financial team, before investing in bonds and bond funds.
This is the risk of the value of your portfolio decreasing as the purchasing power of the underlying securities also decreased, due to inflation. Since we are currently experiencing a low interest rate environment, a portfolio that is invested in conservative fixed income securities may decrease even though the securities are making modest gains. By far, this is biggest argument against keeping your money tucked under your mattress.
Volatility risk refers to the probability of a portfolio’s value to change as a result of the prices of the underlying securities changing. In retirement planning, this is the most important risk of all — it is the true differentiator of a financial advisor from a salesman. For example, say a retiree gives a financial advisor a dollar. The advisor’s job is then to invest their dollar with the highest probability that when they need the dollar back, it is worth one dollar or more. The market, however, is volatile and does not go up forever — moreover, it has a tendency to correct. In 2009, the S&P500 had dropped over 50% from the high in 2007. If a retiree needed to sell their securities in 2009, their dollar would only be worth 50 cents… and, at BARR Financial, we want something different for our clients.
Understanding each of these risks and how they impact your investment is key to limiting the volatility of your portfolio — but you want an experienced and confident team on your side, to help calculate the exact amount of risk you are exposing yourself to and adjust your portfolio as such. A financial advisor who has appropriately aligned your money with what you are trying to get done should be able to provide you with your whole dollar no matter if the market is up or down. BARR Financial Services accomplishes this through a unique strategy called duration investing, a proven process to help you determine if your investments are matching your appetite for risk. We’d love to help you — just give us a call at (407) 622-0018 for a free consultation today.