Halloween is upon us! The season of scary is filled with a crisp chill in the air, trick-or-treaters showing off their costumes and spooky decorations lining the streets. For many investors, though, the fear looming in the shadows isn’t a goblin, ghoul, or ghost; it’s investment risk.
Investment risk is the probability of permanent capital loss. Frequently though, investors forget that permanent is the key word in this definition. Consequently, they believe fixed income securities are safe, since they typically experience less price volatility than their equity counterparts. Conversely, they think all equity is risky and leaves the investor open to losing their total investment. To avoid this risk, investors allocate a large portion (or all) of their portfolio to what they deem are “safe” securities (i.e. fixed income or money market funds). What these investors fail to consider is that risk isn’t just the probability of permanent capital loss…by making a portfolio too conservative, they are exposing themselves to other types of risk. For example:
Credit Risk – the risk the borrower may not repay the loan. Bond holders, in this case, miss out on future interest payments and lose their principal. Yes, even when you invest in relatively safe bonds, it is possible to lose your principal. Relatively safe is not risk-free.
Interest Rate Risk – the risk an investment’s value will change due to a change in interest rates. For instance, if you purchase a 2% interest rate bond today, it may be less valuable in the future. Since bond prices move inversely of interest rates, the price of the bond will fall when interest rates rise. No rational investor would buy a 2% bond if current interest rates are 3%.
Inflation Risk – the risk that inflation will erode your purchasing power. Example: if you purchase a money market fund today and make .25% annually, but inflation is +2.25% each year, your purchasing power (i.e., what you can buy with your dollars) decreases by ~2% each year.
This is by no means a push to immediately put your entire investment portfolio into risky asset types. It is, however, an encouragement to consider your asset allocation not only in terms of your own risk-tolerance, but also in terms of your goals. Is your current allocation consistent with your financial goals and still allowing you to sleep at night? You should avoid constructing a portfolio that helps you “go broke safely” (i.e., subdued volatility, but decreased purchasing power) or creates a “restless night retirement” (i.e., your goals are achieved, but the amount of risk you’ve taken on is terrifying and often keeps you up at night). A good investment adviser can help you find the right allocation to meet your goals and provide peace of mind. Finding this right mix of safety and risk for you is the key to true investment success.