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Investment Risks: What You Don’t Know CAN Hurt You

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I’ve noticed a couple common threads in investment planning conversations across investors of various experience levels and account balances.

investment portfolio

  • Many people don’t understand how their bonds lost so much last year. “Aren’t bonds supposed to be safe?”
  • Others don’t understand why they would put any money in international stocks, when domestic stocks perform so much better? Or invest in the entire U.S. market when the S&P 500 performs better? Or an S&P 500 fund when tech stocks perform better? Or any fund at all, when a single stock, or collection of stocks they own or have been watching has performed better?

So let’s take a look at the different risks that any investment portfolio should address, how different assets address and expose you to different risks, and unique risks we face as we approach and navigate retirement.

Volatility ≠ Risk

We often use the standard deviation measure synonymously with investment risk. Standard deviation (SD) is the measure of total risk. It tells us how much variance there is around an expected return; in other words, how volatile or unpredictable an investment’s returns are. 

It is important to understand SD. However, there is far more to understanding an investment’s risk than knowing its SD. 

Higher risk, as measured by SD, tends to correspond to higher rewards. So an approach that is overly focused on lowering SD, can set you up for an even bigger risk….not achieving your financial goals.

We need a more nuanced understanding of risk. What are the components of risk and how can we mitigate each while still achieving our goals? Let’s look at a few of the biggest risks a portfolio faces.

Unsystematic (Diversifiable) Risks

Let’s start with a few unsystematic risks of stocks. These are risks that can be diversified away, yet a surprising number of portfolios I see fail to do so.

Diversification is psychologically hard, because it guarantees you will never have the optimal portfolio. Some stock, asset class, concentrated fund, part of the world, etc. will always be doing better than your diversified portfolio.

The flip side of that coin is that your diversified portfolio guarantees that you will never have the worst performing portfolio. Something you own will always be performing relatively well.

The latter is far more important than the former. Our first goal is to stay in the game, because these are asymmetric rewards vs. risks.

It would be nice to hit a home run with our investments and become incredibly wealthy. We absolutely cannot afford to get wiped out by taking unnecessary risks. This is especially true as we approach and navigate retirement.

Business, Regulation, and Sector Risk

Business risk is the risk that an individual company may underperform expectations or even fail. We recently witnessed Silicon Valley Bank go from one of the largest banks in the country to bankrupt in a matter of days. Historically, even behemoths like Enron and Lehman Brothers quickly went from billion dollar companies to worthless.

Sector risk is the risk that one sector of the economy such as tech, healthcare, or energy will perform particularly poorly. This can be due to regulatory changes, general economic factors, or innovation that disrupts the status quo.

It’s common for people working for “great companies” or who “know their industry” to overweight their investments towards those companies and industries. They feel their knowledge provides an advantage over other investors. While this could be true, it is also possible that this could lead to overconfidence. Humility is our friend as investors.

Overweighting towards the company you work for or the industry in which you work absolutely increases the risk that a business downturn can negatively impact your income source and investment portfolio simultaneously.

You can diversify away business, regulation, and sector risk by investing in a broadly diversified index fund or ETF like an S&P 500 or total market fund.

Country Risk

A common pattern for people all over the world is home country bias. That is to invest predominantly or entirely in assets from your home country.

Americans will point out that this isn’t as big of a risk for us, because the U.S. represents nearly 60% of the global equity market. While true, this is another way of saying ignoring international markets is to ignore over 40% of the total equity markets.

As noted in the introduction, a lot of people are currently questioning whether it is necessary to invest in international markets at all. U.S. stocks have dominated international stocks over the past 15 years. While true, this is short sighted and misses extended periods where the opposite was true.

For Americans, a home country bias is not totally unreasonable. There are compelling reasons to not hold international stocks. However, it is vital to understand the risk this adds for extended periods of underperformance and the need to be willing and able to stick with your strategy through those periods.

New investors who think they only need American stocks based on recent performance may be buying at inflated prices near the end of a cycle that is about to switch. Even more harmful are people who have held international stocks through a period of underperformance and are ready to give up on them right before it may be their time to shine.

At the end of the day, no one knows with certainty what the future holds. My crystal ball is no better than yours. But if history is any guide, a globally diversified portfolio will pay off over time. Whichever approach you ultimately choose, you must do so with the conviction to stick with it through inevitable periods of underperformance.

Diversifying Away Risk

You can diversify away a lot of risk holding just two funds, a total U.S. stock market index and a total international stock market index. 

Related: Is The 3 Fund Portfolio Right For You?

For someone early in their accumulation mode and with the stomach for a bumpy ride, this may be all you need. However, those bumps can be pretty large. This leads to our next risk that must be clearly understood….

Market Risk

Looking at data for VTSAX as a proxy for the total U.S. market reveals a standard deviation of 18.33%. Using VTIAX as a proxy for non-US stocks reveals a standard deviation (SD) of 20.73%. To use a nice round number, let’s call SD of broadly diversified markets 20%. What does this mean?

Let’s assume a normal distribution of stock market returns (i.e. bell shaped curve) and that stocks will return about 10% annually with about a 20% SD. You will rarely ever have a year with a 10% “average” return. Instead returns will tend to play out as follows:

  • 68% of the time you can expect your returns to fall within +/- 1 SD, or between -10% and 30%. 34% of the time you can expect returns of -10 to 10%.
  • 95% of the time you can expect returns to fall between +/- 2 SD, between -30% and 50%. 13.5% of your returns can be expected to fall between -10% and -30%.

That is a lot of variability before we even get to the real outlier events! Depending on the length of your investing timeframe, you should assume your stocks will drop by about 50% at least once.

For accumulators, those big market downturns can be your friend. They allow you to buy more shares for the same amount of money. But that only works if you are willing and able to keep buying.

For retirees and those nearing retirement who don’t have the ability to wait for markets to recover, this market risk can destroy your plans. This is why we need to diversify beyond stocks to avoid our next two risks….

Sequence of Returns and Liquidity Risk

Sequence of returns risk is the risk that you will have a large market crash or a prolonged period of low returns early in retirement. If you have to take portfolio withdrawals while the portfolio is depressed in value, the portfolio may be depleted to an extent that it will be unable to recover in time to last through your entire retirement. For a comprehensive discussion of sequence of returns risk, I recommend this resource from Early Retirement Now.

Liquidity risk is the risk that you can not create the cash necessary to meet your financial obligations. While a widely traded total market mutual fund or ETF is liquid in that you can sell it and have cash in hand within a few days, their volatility means that you may have to sell at depressed prices.

We need to have a portion of our portfolio in assets that are truly liquid to address these two risks. This means you can access cash when you need it AND at a predictable price. Cash or cash equivalents (high-yield savings accounts, money markets, treasury bills or funds, short-term CDs, etc.) fill this role in a portfolio.

Why take any risk? Why not keep all of your portfolio in ultra-safe liquid assets? Because they expose you to our next risk….

Purchasing Power (Inflation) Risk

Inflation risk is the risk that inflation will increase faster than the rate of return of your portfolio. In practical terms, this means that the dollars you have today will have less purchasing power in the future due to the impacts of inflation.

A reasonable goal for cash or cash equivalents is to keep pace with inflation. Outpacing inflation with cash investments over long periods of time is unlikely. Getting a higher rate of return typically requires investments with more risk.

This is why we should consider bonds with longer maturities in our portfolio. If you can get more yield with longer bonds, why have cash at all? As many investors learned over the past year, intermediate and long term bonds expose us to yet another risk….

Interest Rate Risk

Interest rate risk is the risk that interest rates will rise causing your bond values to fall. This may be counterintuitive at first, but a simple example should clarify.

Imagine buying a $1,000 bond today paying 5% interest, or $50/year. Tomorrow rates go up, and the equivalent bond pays 6%, or $60/year. If you have to sell your 5% bond, it would be hard when someone could buy a brand new bond paying 6%. So you would have to sell at a discount.

How far bond values will drop for a given rise in interest rates is a function of the bond’s duration. The longer time you have until your bond matures and can be reinvested at the new higher rates, the greater the value the bond drops if you need to sell it.

Related: How Low Can Your Bond Values Go?

For that reason, we would want to keep the duration of your portfolio less than or equal to the amount of time you have until you may need the money.

Interestingly, we are currently in an unusual period where short-term interest rates are actually higher than long-term interest rates. With so many of us suddenly aware of the impact of rising interest rates on longer duration bonds, a logical question arises: Why not just keep all of your investments in cash equivalents that don’t have interest rate risk? 

The answer leads to our next risk….

Reinvestment Risk

Reinvestment risk is the risk that interest rates drop and you have to reinvest at lower rates as your bonds mature.

Imagine the same scenario as above with one difference. Instead of rates going up by 1%, this time rates drop by 1%. Your short term bonds will soon mature, and you will have to accept a lower yield on newer bonds when you reinvest.

If you were holding a bond with a longer maturity, you would keep collecting your higher yields until it matured. In addition, when rates drop, the value of your old higher yielding bond goes up. So if you needed to raise cash by selling the bond, you could sell it for greater than its face value.

Keeping all of your bond investments short-term may have made sense a few years ago when the world was coming out of the pandemic. Interest rates were at all time lows and the risk reward profile of longer term bonds made little sense.

Doing so now feels like fighting the last war. After a rapid increase, interest rates are approaching historical averages. We don’t know where they will go from here, so build your portfolios in a way that will work reasonably well without having to predict the future correctly.

All of this discussion about interest rates ignores another big risk of bonds that needs to be mentioned….

Default Risk

A bond is a debt instrument. You are lending money to a company or government entity. They are agreeing to return your capital at a defined point in time and pay interest on your cash in the interim.

As noted above, one way to traditionally command a higher return is to loan your money for longer periods of time, which increases interest rate risk. 

The other way to get higher yields is to loan your money to less qualified borrowers. This increases default risk, the risk that the borrower will not be able to return your money.

There are several ways to limit default risk. If you choose to invest in riskier bonds, you should do so in a bond fund where you can diversify away the risk of holding just a few bonds that could cause serious harm if one or a few defaulted.

Alternatively, my preferred approach is to limit this risk by investing only in high quality bonds with little default risk. U.S. treasury bonds allow you to essentially eliminate default risk. 

However, as with all risks this is a tradeoff. You have to accept lower yields and potentially the need to then take more risk elsewhere in your portfolio to achieve your goals.

Putting the Pieces Together

When building my portfolio and helping others build theirs, I think about every investment dollar having a role, focused on achieving the required investment returns with the minimum amount of risk.

Start with the foundation. This is to have enough liquidity to meet your spending needs. 

  • For accumulators with large positive cash flows and few liabilities, this may be very little.
  • For retirees, having a few years of spending needs held in short-term investments (some combination of high-yield savings, money markets, T-bills, CD’s, bond or CD ladders, etc.), is prudent to meet spending needs through most run of the mill bear markets.

Related: The Next Bear Market — How Bad Could It Get

Next consider how much money you’ll need to allocate to intermediate term bonds. They provide a source of income and stability. (Some people like long-term bonds for traditionally higher yields and better diversification in times of dropping interest rates. I personally avoid them.)

  • For accumulators, the amount will be determined by your risk tolerance and can vary considerably.
  • For retirees, a good goal is to have a total of 10 years of expenses in fixed income assets allowing you to ride out all but the worst bear markets for stocks. Depending on how much is allocated to short term debt instruments, you can fill that bucket with intermediate term bonds. More conservative investors with larger portfolios may want to allocate more money to bonds.

Finally, consider how much risk you are willing and able to take with stock investments. Allocate your dollars between U.S. and international funds focusing on low-cost, tax-efficiency, and broad diversification. 

  • For accumulators with a high risk tolerance and long investing timeframe, this can be the vast majority if not all of your investment dollars aside from any cash savings.
  • For retirees and those approaching retirement, the amount you allocate to stocks will depend on the size of your portfolio and your tolerance for risk.

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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