The Different Flavors of Risk

When we look at the performance of the investment markets so far in 2017, something seems to be missing. We know that it’s there. We can feel it. But we just haven’t seen it in a while. Our monthly and quarterly statements look pretty good, and most of the asset classes we own are doing well. So, what’s missing? We know that risk and reward are basic principles of investing. So far this year, we’ve seen reward, but risk seems to be missing.

When most people think about risk, they are thinking about market risk—the risk that their investments will lose value. Most of us still remember the harrowing years of the financial crisis that occurred a decade ago. We saw the U.S. stock markets drop more than 50% from 2007 to 2009. It was a long, painful decline, and it was a devastating example of market risk.

But risk comes in several flavors. While market risk is the boogeyman that seems to scare folks the most, it’s hardly the only risk we face as investors. One of the main reasons that we invest is to help offset inflation risk. When the prices of milk, eggs, and other living expenses go higher, it takes more money to maintain our standard of living. This flavor of risk is particularly dangerous for retirees. When you are no longer working and are living off your savings, inflation eats away at your purchasing power. The increasing costs of health care as we age are becoming a huge risk for a lot of people. What can we do? We can invest. If we can grow our investments more than the inflation rate that eats away at our purchasing power, we can stay ahead of the game. So, we end up taking on some market risk to help offset our inflation risk.

Longevity risk is the risk that we will outlive our savings. It’s another form of risk that is particularly dangerous for retirees. Thanks to the wonders of modern medicine and improvements in living conditions, we are living longer. This means that we are spending more money and putting more stress on our savings. Longevity risk is bad enough, but when it’s combined with inflation risk, it’s a double-whammy to retirees. Again, we try to mitigate these risks by taking on market risk. If we can grow our savings by investing wisely, we can help offset some of the risk of running out of money in our later years.

There are other risks that we face when investing. Concentration risk is the flavor of risk that comes from having too many of our investment eggs in one basket. If our portfolio is heavily concentrated in one type of investment, an individual stock, a bond, or even an asset class, we risk losing money if that investment does poorly. We can reduce this risk by diversifying our portfolio across many investments, industries, and countries.

Credit risk is the risk we take when we buy a bond or other type of fixed-income investment. When we buy a bond, we are basically lending our money to a company or a government. Credit risk comes from the chance that we don’t get paid back when the bond matures. Once again, this risk can be lessened by owning a diversified portfolio of bonds, or by owning a bond fund.

We can’t avoid risk, because it is everywhere in one form or another. The key to being successful financially is to balance the types of risk. That balance is different for everyone. We accept some of one type of risk to help offset another type. We all have different goals, and we all deal with the different types of risk in different ways. It’s important to find the balance that is right for each of us.

This Is How We Invest, and Why—Part One

The investing world can be a scary place. It can also be exciting. At times, it can seem like there’s nothing to it, and at times it can seem like the most complicated thing you’ve ever done. All of the thoughts and emotions that are part of investing are enhanced because, after all, you are putting your money and your financial future at risk.

Risk and reward go hand in hand when you invest. You can be very conservative and not subject your investments to much risk, but then you are not going to get much in the way of return on your investment dollars. Or you can take a lot of risk, looking for the proverbial home run. That approach can lead to stellar returns, or it can lead to distressing losses.

So what is your strategy when it comes to investing your portfolio? Are you actively looking for that one piece of information that will give you the edge you need to catch the next wave of increasing prices of your favorite tech stock? Or maybe you suffer from “paralysis by analysis,” overwhelmed by the information flow and its potential impact on your portfolio?

There is no shortage of investment strategies that you can follow. In fact, just this morning, we learned of a new strategy. A financial podcast that we listen to discussed a strategy that will buy or sell a company’s stock based on the tweets from our Tweeter-in-Chief, President Donald Trump. If he tweets a positive comment about a company, they will buy the stock. If it’s a negative tweet, they will sell it. Sounds crazy, right? But there are thousands of money managers in the investment world, and thousands of different strategies that they use to try to get their edge.

When it comes to investing for the financial future for our clients, we can’t, and won’t, play games like that. We follow a very disciplined approach to investing, based on a Nobel Prize-winning academic strategy that focuses on controlling what we can control. And we are smart enough to know that we can’t control the markets. This article is the first in a series that will explain our approach and the science behind it.

The First Step: Humility

The first building block in the science behind our investment philosophy is the need to embrace market pricing. While that sounds a little complicated, it’s really not at all. It simply means that the financial markets are very efficient and that all of the information available on a particular stock, bond, or other investment is reflected in the current price. Millions of investors around the world buy and sell investments every day, and the information that they bring to the markets helps to set prices. When some new information affecting an investment comes out, it is immediately factored into the price of that investment.

We like to use the price of Apple stock as an example. If Apple is coming out with a new iPhone soon, you know about it, we know about it, and millions of people around the world know about it. There is no way to profit from any kind of information edge that you might think exists, even if it is only temporary. That’s why it’s not a good idea to run out and buy Apple stock when you hear the news. Years ago, there may have been some pieces of information that took time to work through the markets, but with today’s technology, that time gap has disappeared. Many of us have alerts on our smartphones that let us know in real time when some important news has been released.

So the first step in putting our “evidence based” strategy into action involves being humble enough to know that we don’t know more than “the market.” There are several more pieces that we use to fully build out our strategy. We’ll cover those in future posts.