The headlines are filled with stories on the potential for inflation, rising interest rates, new government economic and taxation policies, fluctuating currencies – including cryptocurrencies — high-priced stocks and more.
Each of those stories, however, represents a different form of risk, and the varied news is the market’s way of suggesting that investors might want to reconsider their approach to risk now, before any of the storm clouds becomes a deluge.
To do that, investors need to look at how risk works and reconsider the various risks they’re facing.
No matter which dark cloud you fear the most, there is no way to avoid all potential issues or quell every fear.
Say, for example, money-losing investments are your biggest fear; if you go all-cash in response, your big worry is reduced but you face an ongoing threat that your money won’t keeping pace with inflation or, perhaps, that you’ll outlive your nest egg.
Even if you take the extreme all-out position, your fear of missing out could be realized if the market keeps rolling while you’re on the sidelines.
To assuage your fears and balance your portfolio both for the market and against risk, consider the various risks you’re facing.
Here is a refresher:
- Market risk, or “principal risk,” is the chance that bad investments or a bear market chew up your money. It can hit both stocks and bonds — when interest rates rise, bondholders see the value of their paper shrink — and for most people it’s the big bugaboo.
With the market at all-time highs and rates poised to increase slightly, investors may want to cull winners and rebalancing a portfolio to reduce market risk.
- Inflation or purchasing-power risk for most people is the “risk of avoiding risk” — the opposite end of the spectrum from market risk — the possibility that you’re too conservative and your money can’t grow fast enough to beat rising inflation.
In recent years, with fixed-income failing to deliver significant yields, many investors used dividend-paying stocks to goose their distributions and overcome the risk of being too conservative; they’re trying to beat back purchasing-power risk, but have taken on more principal risk in the process.
- Interest-rate risk turns on how rates change. If you seek a long-term “risk-free return” by putting your money in a bank certificate of deposit, you face the chance that interest rates rise and your assets are stuck at what has become a below-average rate of return.
That’s particularly true right now, with rates ticking up slightly but looking like there is more ahead. Investors want to be careful about the duration on their bond funds; the more distant the average maturity, the more interest-rate sensitive the fund, which shows up in rising-rate environments, like what most people expect to see in the next few years.
- Income risk is a sister to interest-rate risk, and it’s the chance that an income stream will decline in response to rate changes. Some experts also say it’s about personal income levels.
Investors/consumers worried about long-term income levels can consider income-annuities to provide a consistent, dedicated payment stream.
- Shortfall risk is the chance that you won’t have enough money to achieve your goals, and it’s about you more than the market.
Shortfall risk rises if you’re either too conservative or too aggressive; one way to overcome it is by saving more.
- Special-situation risk involves life events, like planning for college, hosting a wedding, protecting a special-needs child for life, and so on. These situations can be temporary or permanent, but they need to be addressed to make sure that your money delivers more than a number on an account statement.
- Sequence-of-return risk hinges on market circumstances at your time of need. Studies show that if the market tanks as you enter retirement and see income drop, it can reduce your financial security for life, whereas a market boom that coincides with the start of retirement can lock the gold into your golden years.
- A close sister is timing risk, what will be happening at the point when you need your money. While markets historically grow over long stretches of time, short-term prospects are always murky; if you need a definite chunk of money for a specific purpose on a set date, say in two years, timing is a worry.
- Liquidity risk affects everything from junk bonds to foreign stocks to cryptocurrencies.
On a broad scale, it’s the chance that investments in a particular country suffer during a credit crunch, the potential for a thinly-traded stock to be difficult to redeem in a crisis, or the possibility that a hot cryptocurrency can’t be redeemed for cash. It’s also in illiquid securities — like non-traded REITs – which can’t always be redeemed on demand at their perceived value.
- Political risk is the prospect that the government’s broad policy decisions hit home and impact your finances. It’s about the safety of Social Security, health-care affordability, and the grass-roots effects of policies like current infrastructure and tax plans.
- Societal risk is ultra-big picture, looking at world events. This is what might happen in the event of terrorist attacks, war or catastrophe. Some cryptocurrency investors buy coins to help guard against problems with central banks and governments.
Put them all together and it’s a lot of risk.
Diversification involves taking on some or all of these risks, so that no single concern can ruin you.
Thus, investors should read headlines with an eye on whether their portfolio and income stream are vulnerable to any potential pitfalls on the horizon.
In short, if you’re trying to determine where it’s best to invest “now” or “next,” think about how your biggest worries could play out, and whether you’ve balanced out the associated risks.
Ultimately, your choices should be less about generating big profits now than about improving your ability to sleep at night. Being able to relax no matter the conditions is a big win, no matter what the market does next.
Chuck Jaffe is a nationally syndicated financial columnist and the host of “Money Life with Chuck Jaffe.” You can reach him at firstname.lastname@example.org and tune in at moneylifeshow.com.
Copyright, 2021, J Features