Five Types of Risk and How to Deal with Them

Investors face several types of risk, and I contend that it is a mistake to get so focused on just one that the others get short shrift. I often take an informal and unscientific poll to determine which risk is most prevalent in the minds of investors. Lately, because the U.S. stock market (as measured by the S&P 500) has dropped about 12% in the first 4 weeks of this year, a lot of investors found themselves scratching their heads and wondering what is coming next. They see the chief risk as losing their principal — or what I call drawdown.

Drawdown risk. Because most people see the loss of capital, even if it’s only on paper, as their chief risk, most risk tolerance questionnaires ask the question, “How much drop in the value of your investments can you stomach before pulling the plug and going to cash?” A rational investor would not make an investment if he or she didn’t believe the investment was going to go up. Be that as it may, at times rational investors can be wrong. Their investments turn sour and drop in value. The chief risk control is to set a risk budget for each investment and for the portfolio as a whole. Then set an alert on your smartphone to tell you if your investment hits that level and know ahead of time what you are going to do when the alert goes off. If you are right and the investment goes up in value, you can then move up the alert. Meanwhile, scale more money into winners and cut losses.

Let’s look at four more different flavors of risk and what you might do to mitigate the impact of each one.

Loss of purchasing power is experienced during periods of inflation. Inflation is insidious and often goes unnoticed. I dealt with inflation rather extensively in the last issue and will not take up a lot of ink rehashing it here. (If you didn’t see that and you would like a copy, let us know.) Loss of purchasing power can generally be offset with assets that beat inflation by some margin. Some assets, such as commodities, precious metals, and real estate, are usually good hedges against inflation. Stocks, particularly the stocks of companies that are considered defensive stocks with good dividends, have consistently beaten inflation over longer periods. Short-term bonds or CDs are not inflation beaters. Additionally, inflation is the primary risk of most annuity payouts. Real estate works well against inflation because a) property values are likely to increase, and b) investors can raise the rent to match inflation.

Volatility risk. Most investors are quite confident that the stock market will go up over long periods of time. They are also keenly aware that stocks don’t go up in a straight line. While the trend may be up over time, there are a lot of ups and downs in the price of stocks. That is volatility. It is widely accepted in the investment community that asset allocation (i.e., putting your investment assets into several asset classes, some of which move counter-cyclically to others) is a way to deal with volatility. Volatility is typically measured by the standard deviation of the distribution of returns over multiple time periods. Rest assured that a broadly diversified portfolio will underperform the best performing asset or index. However, if you use asset allocation and re-balance the portfolio periodically, you will likely have lower volatility than your neighbor who simply buys and holds. If you have a portfolio with x% return and your neighbor has a portfolio with the exact same return, but you do it with less volatility, you will have more dollars in the future than your neighbor who has the same average return. It’s just the math of compounding.

Risk of failing to achieve long term goals. We so often hear about people who sacrifice their long-term goals for a short-term promise of gain. Future regret is so hard for most of us to appreciate in the present moment while considering an opportunity to invest. This most often gets manifested in taking on too much debt, buying too much house, boat, or car — or simply outliving your resources. To mitigate this risk, it is important to regularly update your financial plan to reflect current circumstances projected into the future using reasonable assumptions. Considering alternative future scenarios (especially worst-case and best-case) becomes very valuable when tradeoffs are present. It is important to construct long-term goals and then break them down into current-year actions that move you closer to the objective. I often advise that if we string together a series of Best Years Yet, we will end up with a well-lived life. Speaking of which …

Longevity risk. Perhaps I should have started with this one. Whenever we do financial planning for a client, we often run the numbers out to age 100 for both spouses. Actuarially, we know that most people won’t live that long, but you and I both know people who have. Do you really want to take that risk? Running out of money before reaching such a ripe old age is rarely anybody’s goal, but it also isn’t something that any of us strive for. Most projections of smooth consumption, adjusted for inflation, show that to be broke at age 100 the asset values will likely peak at around age 92. That fact illustrates the impact of exceptional longevity and the rather large expense of our final years.

All these risks should be addressed in any well-developed financial plan. Talk to your advisor about them today.

Scott Neal is president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville. Email your questions and or comments to scott@dsneal.com