Understanding Investment Risk
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What is Risk?
The risk that concerns most people is called market risk. That’s the possibility of not getting back the amount you originally invested because of a sudden steep decline in stock and bond prices. In other words, you might lose money.
Keep in mind, in the context of investing; when we say “risk,” we’re not talking about fear. Fear is caused by anxiety over a real or perceived danger. In the case of investing, the danger is that the money you’ve invested will decline in value, even temporarily.
On the other hand, risk has to do with the relative volatility of different kinds of investments over time. It’s only by learning about risk that you can start to manage it.
A financial advisor can help you get a handle on risk. Establishing an understanding of your comfort with risk is an important part of putting together a sound financial plan.
Asset Classes and Risk
There are three basic asset classes: equities, fixed-income, and cash or cash-equivalents. Each class has its own associated level of risk. As a general rule, investments with the highest potential return carry the greatest level of risk.
Equities and equity mutual funds, as a rule of thumb, have the most risk. Bonds and fixed-income funds carry a moderate amount of risk, and cash and cash-equivalents have the least. But, be careful, while this is generally true, there are exceptions. For instance, an equity fund, broadly diversified across different industries and company sizes can carry less risk than a high-yield bond fund.
Kinds of Risk
In investing, there are two broad categories of risk: systematic and specific risk.
Systematic risk. Also known as market risk, systematic risk relates to factors affecting the overall economy or broad segments of the securities markets. This risk affects all companies, regardless of a particular company’s financial condition or management. Depending on the investment, it may involve international as well as domestic factors. Examples of systematic risk include interest rate risk, inflation risk, currency risk and social-political risk.
Systematic risk can be mitigated with a strategy called asset allocation. This involves creating an investment portfolio of non-correlated assets. In a correlated portfolio, when a systematic event occurs, all the securities rise or fall together. When a portfolio is allocated across non-correlated assets, a systematic event may cause some assets to go down, while others may be unaffected, or even continue to grow. Asset allocation breaks up the risk and spreads it across your portfolio. For more information on asset allocation, see Managing Risk.
Specific risk. Also known as non-systematic risk, specific risk affects a much smaller number of companies or investments. Generally it’s associated with investing in a particular product, company or industry sector. Examples of non-systematic risk include management risk, legal risk, counter-party risk, and credit risk.
Specific risk can be mitigated with a strategy called diversification. Investors who put all their money into the stock of a single company are subject to this kind of risk. If something happens to that company, the full consequence of the risk is concentrated into that single investment. To counter this risk, investors can diversify by buying many stocks of a similar kind — spreading the risk among them. If something happens to one company, the others may be unaffected or even continue to grow. Mutual funds provide this kind of diversification as one of their many benefits. For more information on diversification, see Managing Risk.
Other Investment Risks. Your investment risk can also be increased if you don’t monitor the performance of your portfolio and make appropriate changes in a timely manner. Meeting regularly with your financial advisor to review performance, your goals, and time frames can help reduce this risk.
Employing risk management strategies doesn’t guarantee a profit or protect against a loss.
What is Volatility?
Volatility refers to the daily ups and downs of investment values over some set period of time. Much maligned by investors and the media when prices plummet, volatility is welcomed when investment values head upward. Yet, when was the last time you heard anyone use the word “volatile” to describe prices going up?
Volatility is often equated with riding a roller coaster, but there’s one key difference: When a roller coaster ride ends, you’re exactly where you started.
That’s not necessarily the case with volatility. Thanks to its upside, U.S. stock values have trended upward over the long term despite steep periodic declines, such as the one that occurred beginning in mid-2007. From a long-term perspective, the declines don’t look nearly as steep as they probably felt at the time.
Two perspectives on volatility. The first chart below illustrates that roller coaster feeling. It shows returns over 25 years, but from the perspective of month-to-month volatility.
Month-to-Month Returns Can Swing Dramatically
Monthly Returns of S&P 500 Index 1989 – 2013
Source: © 2014 Morningstar. Represents Standard & Poor’s 500 Index total monthly percentage returns, assuming reinvestment of dividends. This index is unmanaged and unavailable for direct investment. Chart reflects past results and does not predict future results, nor does it represent the performance of any Franklin Templeton fund.
The second chart uses the same data — returns of the S&P 500 Index over 25 years — but instead of displaying each month; it shows the cumulative return over the long term.
Long-Term Returns Have Trended Upward
S&P 500 Cumulative Return
December 31, 1988 – December 31, 2013
Source: © 2014 Morningstar. Shows performance of S&P 500 Index, with a hypothetical starting value of $10,000, assuming reinvested dividends, starting on 1/31/88. This index is unmanaged and unavailable for direct investment. Chart reflects past results and does not predict future results, nor does it represent the performance of any Franklin Templeton fund.
If you develop the ability to keep your focus on the long term, you’ll have mastered the primary approach to living with volatility’s downside.
What is Inflation Risk?
Inflation risk is the risk that the rising cost of goods and services will result in a loss of buying power. When it comes to inflation, no one gets a pass. For example, if you were to become completely risk averse, and instead of investing, you hid your money in your mattress, you would still be subject to the risk of inflation. The price of what we buy keeps going up. We can’t escape, but we can take steps to reduce inflation’s effects.
Sometimes it’s hard to take inflation seriously when you don’t feel its effects today, tomorrow or even next year. If you ask me for $100 and I can loan you only $97, you could probably still make your purchase. It’s only $3, right?
Three percent inflation for one year is no big deal, but take a close look at how 3% inflation chips away at $100 over 25 years.
What Inflation Does to the Purchasing Power of a $100 Bill
This is a hypothetical scenario using 3% and 5% inflation rates.
Compared to 1979, when inflation topped 13%, the numbers in the above chart are tame. But even a low rate of inflation takes its toll.
Not much escapes the effects of inflation. Social Security and a few traditional pensions have built-in cost-of-living adjustments. If you’re lucky, your paycheck will keep pace with inflation, but that’s not always the case. For example, if you got a 3% raise in a year when inflation was 4%, then your standard of living actually decreased by 1%.
Inflation does the most damage to retirees and those living on a fixed income. Typically, they’re more dependent on investment income than people still collecting a regular paycheck.
Some investments fare better than others. Your real rate of return on an investment is the amount left after inflation is subtracted. Real rates of return give you a more realistic idea of how much you’ll actually have available to spend.
The chart below shows long-term returns for equities, fixed-income, cash-equivalent investments and — cash under a mattress. While inflation reduced the returns of all asset classes, it did more damage to the investments people traditionally think of as “safer.”
Inflation Takes a Bite Out of Your Returns
Annual Returns for 25-year period ended 12/31/2013
Source: © 2014 Morningstar. Stocks are represented by the S&P 500 Index, bonds by the Ibbotson Associates SBBI Long Term Corporate Index, cash equivalents by the P&R 90 day U.S. T-Bill Index, and inflation by the U.S. Consumer Price Index (not seasonally adjusted). Indexes are unmanaged and unavailable for direct investment. Figures shown indicate past performance and do not guarantee future returns, nor are they intended to illustrate performance for any Franklin Templeton fund.
While past performance doesn’t guarantee similar results in the future, these returns tell us that the most conservative investments generally carry the highest inflation risk. Remember, however, that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.
Consider the following strategies to help inflation-proof your portfolio:
- Start investing now to take advantage of the power of compounding.
- Consider investments with a track record of beating inflation.
- Talk with your financial advisor about an investment plan tailored to your personal needs.
Important Legal Information
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This material is provided for educational purposes only and is not intended as investment advice or an offer or solicitation to buy or sell securities.
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