Let’s talk about risk | State College, Pennsylvania
Tom King CFP, CLU, AEP is a Registered Director of King Financial Partners at State College
Risk is inherent in investing and it comes in many forms. Since risk and reward go hand in hand, understanding each major type of risk you face, especially during your retirement years, is critical to your success as an investor. Perhaps most important is managing your risk appropriately, which is an ongoing process as your personal circumstances and market conditions are constantly changing.
Managing risk in your financial plan requires recognizing that every choice you make will involve tradeoffs. For example, keeping most of your assets in cash will reduce your chances of incurring a loss (market risk), but may also increase your chances of outliving your money, known as longevity risk. The key is to understand the different types of risk, how each can be mitigated, and find common ground between them that is reasonable and realistic for you.
Here is an overview of some of the risks you may face as an investor and ways to manage them:
Perhaps obvious, it’s a loss from a declining market and it’s a priority for this year 2022. Market risk is inherent in investing, but the real risk is how you react. If you are exposed to investments outside your comfort zone, you will likely sell in a bear market if your losses are more than you can tolerate. Therefore, you might be inclined to abandon your long-term financial plan at or near the bottom of the market, foregoing any possible subsequent rally – a form of behavioral risk.
Nobody wants to outlast their money, but that risk can be hard to manage because we can’t know how long we need our money to last. Tightly managing your expenses and how much you take out of your retirement portfolio are key here.
Related to longevity risk, this is the possibility that the value of your portfolio will not keep up with inflation. This risk can be mitigated by holding Treasury Inflation Protected Securities (TIPS), but most investors will also need some exposure to the growth potential of stocks.
Interest rate risk
The risk that rising interest rates will drive down the prices of bonds and rate-sensitive stocks like utilities is also particularly relevant. Interest rate risk is higher for bonds with longer maturities and
lower for those with shorter maturities. Diversification is your friend here again.
The good news about rising interest rates is that they generally reduce reinvestment risk, the possibility that income from current bond investments cannot be reinvested at the same or higher rate of return. Holding bonds of varying maturities – what is called a “ladder” of bonds can be a useful strategy here.
If you cannot 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 cabin on top of a mountain with a spectacular view may delight your soul, but it should only be a small percentage of your overall wealth.
Related to liquidity risk, it is the danger of having too much money in an investment, asset class or market sector. The simplest remedy is to choose a maximum percentage of your overall portfolio that you will allow for each holding, then reduce it if things get out of line.
Risk of change
Owning foreign assets exposes you to the risk that changes in exchange rates may affect the value of these investments. There are many ways to protect against or mitigate this risk, so this is not necessarily a reason to avoid international investment opportunities.
Particularly important with emerging markets but also applicable to developed countries, this is the risk that changes in a country’s governance structure, tax laws or economic policies could impact your investments.
First two risk management strategies
It may seem like a long list, but they can be countered, at least in part, by two strategies. While there are others, asset allocation and diversification have always been useful in helping to protect portfolios from various challenges. Although these two strategies are similar, they are not identical and work together.
Since different types or classes of assets react differently to changing economic and political conditions, it is important to have different types in your portfolio. Determining the appropriate asset allocation between stocks, bonds, real estate, commodities, cash and alternative investments will depend on your outlook for domestic and global economies, inflation, interest rates interest, business profits and other factors, and the ability to bear risk or loss. The overall goal is to build a portfolio whose holdings are not highly correlated, i.e. they do not all react in the same way to economic events, which would increase your risk. Asset allocation is a major determinant of long-term investment results, so getting it right can go a long way in identifying and implementing the appropriate level of risk to achieve your goals.
Just as allocating your assets among different classes can reduce overall risk, allocating your funds among different investments in each class can mitigate the risks associated with a specific business or industry risk. For example, large and small cap stocks often behave differently at different stages of the business cycle, so holding both can be advantageous. Asset allocation and diversification do not guarantee a profit.
Nothing is static in the market – there is no “set it and forget it”.
Risk management requires that you regularly review your holdings and make any necessary adjustments to maintain the desired risk profile. Investors today can benefit from highly sophisticated tools to assess different types of risk as well as a wide range of strategies that can mitigate them. Especially now, it is important to understand and pay close attention to the right balance between risk and reward while addressing the multiple challenges you may face in achieving your personal financial goals.
Tom King CFP®, CLU®, AEP® is a registered director of King Financial Partners (222 Blue Course Drive, State College, PA). goKFP.com King Financial is a team of accredited professionals specializing in retirement, investment management, wealth transfer and estate planning. Tom can be reached at [email protected] or (814) 234-3300.
Securities offered by Raymond James Financial Services, Inc., Member FINRA/SIPC.© 2021 Raymond James Financial Services, Inc., Member FINRA/SIPC. Investment advisory services provided by 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 receive the Adjusted Principal Amount or the Original Principal Amount, whichever is greater. Increases in the principal value of TIPS as a result of inflation adjustments are taxed as capital gains in the year they occur, although such increases are not realized until the TIPS are sold or do not mature. Conversely, decreases in the amount of principal 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, different financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Small cap stocks carry higher risk and are not suitable for all investors. Although interest on municipal bonds is generally exempt from federal income tax, it may be subject to federal alternative minimum tax or state or local taxes. Profits and losses on federal tax-exempt bonds may be subject to capital gains tax treatment.