By Scott Roark, MBA, PhD | June 5, 2020
In all of life, we face risk. Some of these risks are for possibilities that are extremely remote (lightning strike, shark bite, lottery win). And in many cases, we can effectively eliminate these risks (don’t play golf in a thunderstorm, don’t swim in the ocean with a papercut and don’t buy lottery tickets).
In the investing arena, there is risk as well. Many people equate the stock market with risk – and there is certainly a fair amount of risk in that world. But there is also risk involved in buying bonds (even treasury bonds!) and even in having ultra-safe holdings like money market funds or CD’s. In the space below, I’ll briefly discuss a (non-exhaustive) list of risks that are faced by everyday investors and I’ll finish by discussing proven ways to manage these risks.
Risks Faced By Stock Investors
Without a doubt, there are sizable risks faced by investors who purchase stocks or stock funds. Among these are the following:
- Market risk/Macroeconomic risk – this is risk faced by all equity investors and is related to the overall market climate. If the economy moves from expansion to recession, most firms will feel the effect and have poor returns as a result. Interest rate changes, oil price shocks and legislative changes (tax code) can have broad impacts on the economy in general and on stocks in particular. These risks are most easily seen when most firms in the market take a drop together.
- Industry specific risk – this is the risk that companies in a particular industry will be hurt by some factor. For instance, if the price of oil increases significantly, then industries that have fuel as a significant input will be especially hit. If jet fuel prices increase dramatically and for a long period, the share price of airlines will likely be hurt much worse than companies in general. These kinds of risks are most easily seen when many companies in a particular industry drop together – and they drop much more than the overall market.
Other examples of industry specific risk might be litigation risk, where lawsuits have a negative impact on the entire industry. Think of tobacco settlements or a class action lawsuit that puts a big dent in a firm’s share price.
- Company-specific risk – this is the risk that something will happen to an individual company that causes its price to drop, even while other companies might do well. An example might be a CEO who is arrested for embezzlement and whose company’s stock takes a dive. The rest of the market isn’t likely to be affected by this one person’s criminal activity so the decline in the share price of this company may be quite isolated and really stand out.
Risks Faced by Bond Investors
While generally the risks faced by bond investors are lower than for stock investors, there are still sizable risks that bond investors must face. Among the biggest risks are these three:
- Default risk – this is the risk that the borrower will not pay some or all of what they have agreed to pay. This is largely reflected in the credit rating that a bond will have. If it is a “junk bond” (known more generously as a “high-yield bond”), there is a higher risk of default compared to an “investment grade” bond. The bonds with the lowest default risk are U.S. Treasury securities.
When companies go through hard times, the likelihood of default and bankruptcy goes up. In the past month, there have been several firms that have filed for bankruptcy and whose bonds have been adversely impacted. If you own a JC Penney bond, it is a virtual certainty that the bond won’t pay all the promised interest payments or pay back the face value of the bond upon maturity.
- Interest rate risk – this is the risk that interest rates will change in a way that hurts the value of the bond. For most bonds, this risk is really about interest rates going up. When that happens, the value of a typical bond goes down (bond prices and interest rates move in opposite directions). How much the value of a bond will move based on interest rate changes is frequently estimated by looking at a bond’s “duration”. This can be frequently found by looking at a financial website. Bonds (or bond funds) with higher duration will be more impacted by interest rate changes.
Consider two types of bond funds – one a “short-term” bond fund (with a relatively low duration) and one an “ultra-long” bond fund (with a very high duration). At the time this is written (in mid-May 2020), the year to date change in value of short-term bonds has been an increase of about 3.5% because interest rates have fallen this year. However, ultra-long bond funds have gone up close to 30% over the same time frame. If interest rates had increased by the same amount, then these bond funds would have fallen by 3.5% and 30% respectively. Long-term bond funds are definitely not without risk!
- Reinvestment risk – this is the risk that interest rates will decrease and when a bond matures, it will be reinvested into a bond with a lower interest rate and so interest income will decrease. This particular risk has been a persistent one over the last 10+ years – where interest rates are so low that generating income from bond holdings is increasingly difficult.
Risks Faced by Savers
Even people who save money and buy CD’s or money market funds aren’t immune from risk. While it is true that they don’t face default risk (especially if there is FDIC insurance or government backing of money market funds), they do face one especially nasty risk:
- Inflation Risk – this is the risk that price levels will increase over time which erodes the value and purchasing power of money. Even at a relatively low level of 2% inflation, there is a significant deterioration in purchasing power over a 30-year retirement horizon. If inflation averaged 2% per year for 30 years, things would cost about 80% more in 2050 than they do in 2020. And as retirees probably understand, just because overall inflation is 2% doesn’t mean that the specific goods and services you consume will have the same inflation rate. Healthcare has had a higher inflation rate – and if healthcare inflation averages 5% for 30 years then something that costs $500 today will cost over $2,160 by 2050.
If the returns from your investments/savings aren’t keeping up with inflation, then you are losing purchasing power and you are worse off in the future – even if your account balance hasn’t gone down.
With all these risks to consider, it might be daunting to think about investing at all. But by diversifying your holdings (spreading your investments among stocks, bonds and cash), you can mitigate these risks. A diversified portfolio doesn’t eliminate the risks, but they are definitely reduced. Stock values will tend to increase by more than inflation over long periods of time. Bond holdings will tend to reduce the overall volatility of a portfolio that includes stocks. And having some cash is always a good thing – you can use it to pay for things without having to sell holdings that may have gone down in value for the time being.