Tom King CFP, CLU, AEP is Registered Principal of King Financial Partners in State College
Risk is inherent in investing, and it comes in an array of forms. Since risk and reward go hand in hand, understanding each major type of risk you face, especially in your retirement years, is crucial to your success as an investor. Perhaps most important is managing your risk appropriately, which is an ongoing process since both your personal circumstances and market conditions are always evolving.
Managing risk in your financial plan requires acknowledging that every choice you make will involve tradeoffs. For example, keeping most of your assets in cash will lower your odds of suffering a loss (market risk) but may also increase the chances that you’ll outlive your money, what’s known as longevity risk. The key is to understand the different types of risk, how each can be mitigated, and find a middle ground among them that’s reasonable and realistic for you.
Here’s a look at some of the risks you may face as an investor and ways to manage them:
Perhaps obvious, this is a loss from a declining market and is top of mind this 2022 year. Market risk is inherent in investing, but the real risk is how you react. If you’re exposed to investments outside your comfort zone, you’re likely to sell in a down market if your losses are more than you can tolerate. As a result, you may be inclined to abandon your longterm financial plan at or near a market bottom, forgoing any possible subsequent rally – a form of behavioral risk.
No one wants to outlive their money, but this risk can be tricky to handle since we can’t know just how long we need our money to last. Closely managing your expenses and how much you’re withdrawing from your retirement portfolio are the keys here.
Related to longevity risk, this is the possibility that the value of your portfolio won’t keep up with inflation. This risk can be mitigated by owning inflation-protected Treasury securities (TIPS), but most investors also will need some exposure to the growth potential that comes with stocks.
Interest rate risk
Also particularly relevant now is the risk that rising interest rates will push down the prices of bonds and rate-sensitive stocks such as utilities. Interest rate risk is higher for bonds with longer maturities and
lower for those with shorter maturities. Diversification is your friend here once again.
The good news about rising interest rates is that they generally reduce reinvestment risk, the possibility that earnings from current bond investments cannot be reinvested at the same or higher rate of return. Holding bonds of varying maturities – what’s called a bond “ladder” can be a useful strategy here.
If you can’t sell an asset when you want and in the quantity you want without a major impact on the price, you have liquidity risk. For example, that quirky mountaintop cabin with a spectacular view may thrill your soul, but it should represent only a small percentage of your overall wealth.
Related to liquidity risk, this is the danger posed by having too much of your money in one investment, asset class or market sector. The simplest remedy is to pick a maximum percentage of your overall portfolio you will allow for any single holding and then trim it back if things get out of line.
Owning foreign assets exposes you to the risk that changes in currency rates may impact the value of those investments. There are a number of ways to hedge against or otherwise mitigate this risk, so it’s not necessarily a reason to avoid opportunities in international investments.
Particularly important with emerging markets but also applicable to developed nations, this is the risk that changes in a country’s structure of governance, tax laws or economic policies may impact your investments.
Two initial strategies for risk management
That may seem like a long list, but they can be countered, at least in part, with two strategies. While there are others, asset allocation and diversification have historically been useful in helping protect portfolios from various challenges. While these two strategies are similar, they are not the same, and they do work together.
Because different types, or classes, of assets respond to changing economic and political conditions in different ways, it’s important to have different types in your portfolio. Determining the appropriate asset allocation among stocks, bonds, real estate, commodities, cash and alternative investments will depend on your outlook for the domestic and global economies, inflation, interest rates, corporate profits and other factors, as well as the ability to take on risk or loss. The overall goal is to construct a portfolio whose holdings are not highly correlated, meaning that they don’t all react to economic events in the same way, which would increase your risk. Asset allocation is a major determinant of long-term investment results, so getting this right can go a long way toward identifying and implementing the appropriate amount of risk on your way to achieving your goals.
Just as spreading your assets among different classes can reduce overall risk, dividing your funds among different investments within each class can mitigate the risks associated with a specific company or industry risk. For example, large-cap and small-cap stocks often perform differently at different stages of the economic cycle, so holding both can be beneficial. Asset allocation and diversification do not guarantee a profit.
Nothing is static in the market – there’s no “set it and forget.”
Risk management requires that you review your holdings regularly and make the adjustments needed to maintain your desired risk profile. Today’s investors can benefit from highly sophisticated tools for assessing different types of risks as well as a wide array of strategies that can mitigate them. Especially now, it is important to understand and pay close attention to the right balance of risk and reward while also meeting the multiple challenges you may face in meeting your personal financial objectives.
Tom King CFP®, CLU®, AEP® is Registered Principal of King Financial Partners (222 Blue Course Drive, State College, PA). goKFP.com King Financial is a team of credentialed professionals specializing in retirement, investment management, wealth transfer, and estate planning. Tom can be reached at [email protected] or (814) 234-3300.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC.© 2021 Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. King Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services.
The principal of Treasury Inflation-Protected Securities (TIPS) increases with inflation and decreases with deflation, as measured by the Consumer Price Index. At maturity, you are paid the adjusted principal or original principal, whichever is greater. Increases in TIPS principal value as a result of inflation adjustments are taxed as capital gains in the year they occur, even though these increases are not realized until the TIPS are sold or mature. Conversely, decreases in the principal amount due to deflation can be used to offset taxable interest income. If sold prior to maturity, an investor will receive the then-current market value, which may be more or less than the original cost. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Small-cap stocks involve greater risk and are not suitable for all investors. While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax or state or local taxes. Profits and losses on federally tax-exempt bonds may be subject to capital gains tax treatment.