What do we mean by risk?
Investors and savers face risk no matter what, whether they are completely invested in the market or prefer to keep cash in the bank or under a mattress. It is important to understand how to categorize these different risks and understand how they will affect your retirement.
- Unsystematic risks are specific risks, meaning they are risks that are specific to a company or industry and can be minimized through diversification. Usually, unsystematic risks may affect one type of investment while not affecting another type of investment at all. For example, if you buy the stock of a specific company, like Amazon, your risks can be minimized by not buying only Amazon stock, but by buying ETFs and Mutual Funds that invest in hundreds of different companies. Other examples of unsystematic risk are business risk, credit risk, political/country risk, executive risk, manager risk, and legislative risk.
- Systemic risk is general risk, usually due to the system as a whole and not something in the system. It is basically unavoidable and you cannot minimize these risks through diversification. It is the risk that comes with choosing to invest in the market as a whole, such as market risk, interest rate risk, purchasing power risk, exchange rate risk, and reinvestment rate risk. We will discuss these more below.
Risk is going to mean different things to different people. Some people want more risk, like speculators expecting a higher return in riskier mutual funds, while others avoid unnecessary risks by having insured deposits at banks. Risk is personal and you need to evaluate your situation to see what decisions around risks really need to be made. Risk is neither good nor bad by itself.
There are five basic categories of investment risk:
Market risk is the possibility that an investor might experience loss due to factors that affect the financial markets. Some markets can disappear due to a change in consumer tastes (like Beanie Babies). If you are going to invest it is important to choose the right markets.
Most investors are going to spend decades saving for retirement with a majority of the money invested in the stock and bond markets.
Volatility is one way to measure the change in prices. Volatility can be measured over seconds, days, weeks, or even longer periods like years and decades. It is important to understand that while saving for retirement that the day-to-day volatility is not as important as the long-term volatility of your accounts.
Stocks and bonds tend to move in cycles, with periods of growth (called bull markets) and periods of falling prices (bear markets). Different cycles can last different times; the most recent bull market ran for over 10 years. Most retirees will live through at least one bear market, so it is important to keep this in mind.
Interest Rate Risk
Interest rate risk is the potential for losses that come from a rise or fall in interest rates. When interest rates rise, fixed-income investments such as bonds will decrease. When interests decline, the price of a bond will increase.
The world’s capital markets are intertwined with interest rates, because interest rates dictate savings account earnings, the cost of loans, and almost every aspect of the economy for the Mom & Pops and Big Business alike.
While saving for retirement, interest rates are going to greatly affect how much of your income you need to save. If interest rates drop, it might lower the growth rates for common savings vehicles, such as IRAs and 401Ks. It might also warrant you to invest more aggressively for higher returns when you are younger and working.
Inflation, or (Loss of) Purchasing Power Risk
The prices of goods and services tend to increase over time. The rate of this increase is called inflation. Because inflation increases prices, your money becomes less valuable every year. This is why inflation risk is also called “Loss of Purchasing Power” risk.
Inflation can occur even if you don’t invest your money. It would take over a thousand dollars today to buy the same amount of goods as a hundred dollars in 1950. That is an inflation rate of 3.44% per year.
Economists and financial professionals often use 2.5% or 3% as an estimate of inflation over long periods of time. But this rate can under-represent the inflation of certain goods or services, like health care, and it is not a great predictor of short-term inflation.
Retirees on a fixed income are especially prone to purchasing power risk. Even with cost of living adjustments on Social Security retirees can be squeezed. For example, health care tends to be one of the largest expenses for retirees, and the cost of health care tends to increase at a greater rate than other goods, like food and gasoline.
Cost-of-living adjustments are not guaranteed annually for Social Security. Many pensions lack any type of cost-of living or inflation adjustments, meaning your income is likely to not increase at the rate of inflation.
One of the most important characteristics of your investments is liquidity. Liquidity is the ability to market something at a price similar to what it’s considered to be valued at.
For example, cash is liquid; you can easily convert $100 cash into $100 worth of food. Reversing this is not as easy. The food can be sold, but it would be hard to sell back this exact food you just bought for the $100 you paid for it, since it is an illiquid asset. Having money when you need it is more valuable than wealth that is tied up, or illiquid.
Real estate is the most common example of an illiquid investment. Short-term financial needs cannot be met with illiquid investments; keeping an appropriate amount of liquid assets will help protect you from liquidity risk.
In retirement, many choose to have the majority of their wealth invested in real estate or their home equity. If a long term care crisis, or something like this, occurs, you’ll need money immediately. Selling a property for a fair price can take months, if not years. Selling at a steep discount, or a “fire sale”, could allow you to sell it more quickly. That difference in sales price is due to the illiquidity of real estate.
The risk of not being paid by the institution backing a security or insurance policy is called credit risk. This is the risk that the payor cannot pay the payee. This situation can occur between a lender and a borrower, or between any other two parties when one party cannot live up to their obligations. This is also called counterparty risk.
It is important to evaluate who you lend money to; by reviewing the counterparty’s financial strength and their ability to pay back funds is important. Buying government securities like Treasury notes and bonds is one way you can limit your credit risk.
Investors the world over purchase debt from the United States Treasury because of the “full faith and credit” clause of the Constitution that empowers the government to tax. This clause is seen as a backstop, or guarantee, that gives these Treasury notes and other government debt a “risk-free” status. For other investments, investors commonly rely on the major rating agencies such as AM Best and S&P to analyze the default risk of corporations and municipalities.
Credit risk is especially relevant to investors in retirement because they are past their working years and unable to earn back their losses.
How do I reduce my risk in retirement?
The most obvious answer to this question is going to be to diversify your investments and entire financial plan. Simply, do not put all your money in one place, and if you can, don’t rely on just one source of income. The chart below offers a simplified way to compare investments vehicles and their risk:
Many retirees have turned to insurance products to reduce the risk in their portfolio. This migration to annuities and life insurance has been happening for a while, but significantly increased in the weeks following the March 2020 crash.
What’s so appealing about annuities and cash value life insurance? The guarantees. A guarantee of principal. A guarantee of income with annuities. A guarantee that income will continue for the rest of your life.
The guarantees of annuities and cash value life insurance are invaluable, especially for retirees who are risk averse. While we would never suggest putting all your savings into one of these products, having one or even multiple annuities or cash value life insurance policies can help to significantly diversify your portfolio and protect you from losses.
Risk is inevitable, you will encounter it throughout your lifetime of investing. The most important aspect is that you make sure your portfolio is diversified and talk to an experienced financial advisor who can make sure your risk tolerance is aligned with your investment strategy.
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