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How Much Risk Is Appropriate For You?

Risk is one of the most controversial topics for investors, but often times can also be one of the least understood. You can summarize risk in a six word sentence. "Risk is everywhere, and is unavoidable." I often meet individuals that have fixed interest accounts like a CD or an annuity and say that their fixed account is risk free. Well, that may be true of market risk, but the assets invested are not free of all the various types of risk. Today's topics are some various types of risk, and some helpful tips to help you determine how much risk is appropriate for you. Let's start by defining common investment risks.

  1. Market Risk

This is perhaps the most commonly referred to risk when individuals think about risking funds in an investment. Market risk is the risk that when you invest in a security like a stock, the market value of that security could decrease, and lower resale value of the security you purchased. You could perhaps purchase ten, one hundred, or even thousands of different securities to diversify the risk of your portfolio, but regardless of how many securities you purchase, you can not eliminate that market risk from your portfolio.

  1. Credit Risk  

Sometimes investors will lean towards bonds over stocks in their portfolios as their risk tolerance becomes more conservative. The reason for this is that if a company becomes insolvent, a bond holder is considered a creditor of the issuing firm. The issue here is this exposes the bond holder not just to market risk of the bond they carry, but also credit risk, sometimes called "default risk". Bonds will typically pay a "coupon" which is essentially an interest rate that the issuer pays to the bond holder on a basis determined by the issuer at the time of issuance. Credit/default risk is the risk that the issuing company is unable to pay either the interest on its bonds, or to be able to repay the issued debt when the bond is due for repayment.

  1. Inflation Risk

Inflation risk is a less obvious risk when looking at your investments on a day-to-day basis. Inflation risk is the risk that the purchasing power of your invested funds will be decreased over time. For example, imagine you purchased a fixed annuity that were to pay you $500.00 per month in retirement, which is about what your groceries currently cost. If over the next 20 years the price of groceries increases 40%, then 20 years from now the same groceries would cost about $700.00 per month, but your annuity income is still only $500.00 per month. Inflation risk could be a problem for future income in retirement if not taken into consideration when building your investment portfolio.

  1. Liquidity Risk

Liquidity risk is another important consideration when building an investment portfolio, or planning for the future. Liquidity risk is the risk that funds will not be accessible when you may need to access them at an unexpected time. Keeping a portion of your investments liquid is important to be prepared for the unforeseen circumstances that life can sometimes throw in front of us.

  1. Regulatory Risk

Regulatory risk which is sometimes known as "legislative risk", is the risk that changes to laws or regulations could impact your investments. For example, imagine you were to invest in a very quickly growing technology firm and then a new regulation was passed which would hinder the company's ability to grow, and therefore impact your investment's performance.

  1. Reinvestment Risk

Reinvestment risk is a risk that is often associated with funds invested into bonds and other fixed-income investments. Reinvestment risk is the risk that the investor may not be able to reinvest funds from a previous investment into a similar investment to produce a similar rate of return. For example, if an investor's current return for an investment is priced to yield 3%, but interest rates on new investments have lowered to 2%, the investor may not be able to continue earning the same rate of return on his/her next investment.

  1. Foreign Risk and Currency Risk

Lastly we have foreign risk, which has a few factors involved. When an investor purchases an investment in a foreign company or government, they are open to foreign risk. Foreign risk carries market risk, legislative risk, liquidity risk, and currency risk of the foreign nation where the funds are invested. For example, an investor may invest in a foreign company that could suffer from legislative changes to that company's laws. The investor could also be unable to sell their investments abroad as easily as domestically, and then also be unable to exchange the foreign country's currency at a similar exchange rate back to USD as when initially investing in that country.

Now that we have discussed the different types of risk, the next step is to determine how much risk is appropriate for you. The first step is to complete a risk tolerance questionnaire. To do so, we want to discuss your investment objectives (growth, income, preservation of capital, etc.), your investment time horizon, your previous investment experience, your current knowledge of investments, and the level of volatility you feel comfortable with seeing in your account. We use these discussions to determine how conservative or aggressive your investments should be. For example, an investor with a long time horizon to retirement, with a goal of growth, and feeling comfortable with a high level of volatility in their account may meet the profile of a more aggressive investor. In contrast, an investor who is reaching retirement age, is concerned about volatility, and whose main focus is income may take a more conservative approach. This is one of the most important conversations to have when it comes to picking investments and retirement planning. If you aren't sure about how much risk you are currently taking in your portfolio, or how much risk you should be taking, let us know and we would be happy to help answer all of your investment risk questions.

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