Letter to Our Clients - November/December 2005
To our clients and friends:
“I want to make just enough to keep ahead of inflation and taxes, and—oh, by the way, I don’t want any risk.”
But, what is “risk” anyway? “Risk” is the likelihood that a course of action will not deliver a desired result. “Financial risk” is often defined as the measurable uncertainty about investment return. An entire industry has grown up arguing about how best to measure financial risk, but as yet there is no agreement about how it can be done, or even whether it can be done.
When I ask clients what they mean by risk, generally they answer that they do not want to “lose” money. That seems obvious enough, but digging deeper we find confusion about what it means to “lose” money. Obviously having a single investment or an entire portfolio going to zero qualifies, but in a diversified portfolio this is not a particularly meaningful risk. Instead, people tend to think that “losing money” means an investment or a portfolio at any given time will be worth less than it was at some earlier point.
If this were true, the only “safe” investment would be one that
- guarantees at predetermined intervals to add a set dollar amount to a principal
- that is fully guaranteed always to be available whenever the investor wants it, and
- where the addition to principal is always higher than the combined effect of inflation and taxes.
I will argue that no such investment has ever existed, and invite you to contact me if you think you know of one. However, even if such a product did exist, it would still have “opportunity risk,” the risk that the “safe” investment would not deliver returns competitive with what other non-guaranteed investments might be able to generate.
If there is no investment that is truly risk-free, what then are the risks which must be considered before making an investment decision? I can identify fourteen, and there may be even more. Some can be avoided, but not all. Those that cannot be avoided must be acknowledged and managed.
1. Principal Risk. This is the risk that an investment will become worth significantly less or worthless because of bankruptcy or default.
2. Purchasing Power Risk/Inflation Risk. This is the risk that more dollars will be required in the future to purchase goods and services than it takes today. Most products that guarantee an interest rate and return of principal are exposed to this risk.
3. Interest Rate Risk. This is the risk that the immediate resale value of an investment will be worth less than it was at time of purchase as interest rates rise, because a dollar invested today (with interest rates, for example, at 5%) can earn more interest than a dollar invested in the past (for example, at 3%).
4. Reinvestment Risk. This is the risk that when a guaranteed product matures, interest rates for a new investment will be lower than the interest rate of the just-matured product. This was a problem for individuals who invested in bonds in the 1980’s, when interest rates were in double digits. As their old bonds matured (say in 2002), rates on new bonds were in the low single-digits. For many this resulted in a significant drop in income and lifestyle.
5. Timing Risk. This is the risk that an investor will buy an investment (such as a stock, bond, real estate property, business, etc.) just before the price drops, or sell just before the price rises.
6. Market Risk. This is the risk that the entire asset class will move up or down, without regard to the underlying health or soundness of the specific investment. For example, stock of the world’s soundest company is likely to go down in a market “crash,” and US Treasury Bonds (considered to be the world’s safest as it relates to risk of default) will go down in value during a rising interest rate environment. Note: In the 1990’s, the only major asset class to lose value in a calendar year was the US Treasury market in 1994, when the Fed raised interest rates higher and faster than anyone expected.
7. Credit Risk (sometimes called Economic Risk). This is the risk that an entity’s fiscal health has deteriorated to the point where investors no longer have confidence that investments (bonds or stocks) in the entity will pay as promised, resulting in a significant reduction in the market value of that investment.
8. Liquidity Risk. This is the risk that an investment might not be readily convertible to cash. This is often true of real estate or privately-held businesses, but it can also occur with bonds and stocks.
9. Country Risk. This is the risk that developments in a country will create extremely favorable or unfavorable investment situations.
10. Currency Risk. This is the risk that one country’s currency will fluctuate in value and result in positives for some investors and negatives for others.
11. Longevity Risk. This is the risk that we will outlive our money, our friends, our competencies and even our family.
12. Co-dependency Risk. This is the risk associated with structuring a lifestyle or future based upon someone else’s financial resources. For example, a retired couple’s income often declines when the first one dies, as a social security or pension check is discontinued. Or, if the spouse who dies is the primary income-producer or investment manager, the survivor’s financial security will be jeopardized.
13. Decision-making Risk. This is the risk that we will make decisions from panic, fear or greed when a rational process would have led to a more sound result. It can also be the avoidance of a decision—either because of fear of making a mistake or an unwillingness to confront an issue.
14. Don’t forget — Opportunity Risk!
This is not a perfect world. Every investment decision has an uncertain outcome, and requires a balancing of desired gain versus potential negative consequences. We want to help you manage your financial life in such a way that you are clear about your goals, and that you understand the risk/reward possibilities of the choices available to you as your seek to reach these goals.
Please contact us if you have year-end planning issues, or if your new understanding of risk makes you want to revisit your financial management strategies. Please be especially sure to contact us if you have the perfect risk-free investment! And, finally, best wishes for the upcoming Holiday Season.
Robert K. Haley, JD, CFP®