“In order to manage risk, we must first understand risk.... What makes it so risky?”
This is a classic line from an episode of Seinfeld that was on last week. George had to give a presentation about risk management, a subject about which he knew nothing. I was reminded that risk is something most people either misunderstand, or don’t completely understand, so I think a quick refresher is in order.
When people think of risk within their portfolio they typically only think of equity risk; that is the risk that the value of their stock investments will decline. While equity risk is an important factor to consider, there are several other types of risk inherent to your portfolio that you may not be as familiar with, and which can be just as impactful as equity risk.
In order to counter equity risk, many people will invest a portion of their portfolio in bonds. While this can help smooth out the volatility of their portfolio, bonds are not without risk themselves. Not the least of these risks is interest rate risk. This is the risk that interest rates will rise, which can force the value of bonds to decline. With interest rates at or near record lows, interest rate risk should be a major consideration when constructing your portfolio.
Let’s say you’re a bank, and for the last year you’ve been writing mortgages at 3%. Many banks will sell their mortgages to other banks. If interest rates increase to 5%, how likely will you be to find a buyer for your 3% mortgages? It will be difficult, and you’ll probably need to lower your price to entice a buyer and compensate for the rate difference. The same thing can happen with many of the bonds in your portfolio.
There is a fallacy out there that bonds are “safer” than other investment vehicles, and that a person’s portfolio should drastically shift toward bonds upon retirement. As an industry, financial professionals have not done a good enough job of combatting this line of thinking.
One reason this is untrue is another type of risk: concentration risk. This type of risk occurs when a portfolio is tipped too heavily to one type of investment and is a result of having too many correlated investments. Stocks, bonds, commodities, real estate, etc., behave differently under different conditions; they are uncorrelated. When you have too much concentration in just one type of investment, they can all move in the same direction at the same time. This includes down!
Inflation risk and longevity risk go hand-in-hand.
Inflation risk is the risk that your assets aren’t growing enough to outpace inflation. I’ve met many people invested primarily in CDs, who think their money is safe. In truth, because of inflation risk, they are simply losing money safely. Mitigating inflation risk to help ensure your assets maintain purchasing power is an important consideration in constructing and managing your portfolio.
Longevity risk is simply the risk that you will exhaust your assets before you die. The key to defeating longevity risk is in understanding how hard your assets must work in order to help ensure you are able to maintain your standard of living. Once you have determined how aggressively you must be invested, you can arrive at an investment mix which is appropriate. If you undergo a formal analysis to help make this determination, you may find that you are actually more aggressive than you need to be.
Managing risk is a trade-off. For example, in order to minimize inflation and longevity risk, you may need to subject yourself to more equity risk.
Once you have a better understanding of the various types of risk affecting your portfolio, you will start to view your investments in a different way. You’ll suddenly realize that a 100% bond portfolio can be very risky, when you account for interest rate, longevity, inflation, and concentration risks. In fact, a 100% bond portfolio can have more total risk than a portfolio consisting of 60% stocks and 40% bonds!
Work closely with your Certified Financial Planner professional to better understand the types of risk you are facing, and how best to manage them. Together you can devise a plan that’s sensitive to your unique circumstances.
Stephen Kyne, CFP® is a Partner at Sterling Manor Financial in Saratoga Springs and Rhinebeck.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.
