Investment Risk Management: What Savvy Investors Should Know

People often see themselves as either “fully invested” or “not invested” in the markets, or consider their holdings as either “risky” or “safe.”

But investment risk is not either/or, and investors may not always consider the varying degrees of risk in between. There are endless options between putting money under your mattress and betting it all on black.

All investing involves some level of risk, and we walk through investment risks with clients all the time. If they invest too aggressively in stocks, the potential benefits may not outweigh the risk they’re taking on. But if they avoid risk altogether by selling or moving everything to conservative investments like money markets, that adds another type of risk. Selling during a market downturn can make it difficult to get back into the market to participate in the next upswing.

Learning how to manage different types of risks can help you create an investment portfolio to help you work toward your financial goals.

Understanding Investment Risks

Two general types of investment risk are market risk and credit risk. Market risk refers to the possibility that investments might lose value due to fluctuations in interest rates, geopolitical events or recessions. Credit risk comes into play if a government or other bond issuer fails to repay interest or principal.

Lesser-Known Investment Risks

In addition to market risk and credit risk, there are many other types of investment risk:

• Allocation/Concentration Risk
  When you’re heavily invested in one asset class or a single stock, allocation risk (also called concentration risk) can come into play. For instance, if someone holds a large chunk of their retirement account in their employer’s stock, that puts them in a precarious position if the company fails. Not only could they lose their job, but they’d also lose a big chunk of their nest egg for retirement. That’s why it’s so important to maintain a more diversified investment portfolio of different asset classes and different stocks.

• Sequence Risk
  When investors nearing retirement suffer a loss in the value of their portfolios, it’s more detrimental than a loss suffered by younger investors who have more time to recover from the loss. This is known as sequence risk. This is why retirement investment portfolios should be adjusted over time. Younger investors with a longer time horizon can afford to invest more aggressively because they have time to recover from a potential loss. But as they get closer to retirement, they may want to downshift to a more moderate strategy so that they’re less susceptible to potential losses.

• Longevity Risk
  As people live longer, retirees may need their money to last three or more decades after they leave the workforce. The possibility of outliving that money is called longevity risk. There are a number of strategies available to hedge against this risk. For instance, retirees can consider taking Social Security strategically. They may also consider not being too conservative too early in retirement, so the money has the potential to keep growing.

• Inflation Risk
  If your money loses purchasing power due to a rise in the cost of consumer goods and services, that’s known as inflation risk. Cash and bonds are most susceptible to this risk, which is why you want a diversified investment portfolio to hedge against this risk.

• Headline Risk
  This is the possibility that a news story will adversely affect a specific investment, a specific sector or the entire stock market. Investors can best mitigate this risk by sticking with their fundamental long-term strategy and ignoring short-term fluctuations that can be triggered by headlines.

• Geopolitical Risk
  Unstable governments and monetary policies in other countries can impact financial markets and your investments.

Financial Planning: How Does the Fear of Loss Affect Your Risk Choices?

Market volatility often leaves investors nervous about seeing their balances decrease, even though volatility can move account balances both up and down.

“Loss aversion” refers to the preference to avoid losses over an equivalent gain. People would rather not lose $5 than to unexpectedly find $5. Or they’d feel worse about a sudden salary cut of 10% than they’d feel good about a surprise 10% raise.

Why? We don’t want to lose something we think we already have, and it changes how we think about investing. It’s important to understand how you might feel if the value of your accounts suddenly changes.

Investment Strategies for Where You Are

Your portfolio should change over time, as should your relationship with risk. But it’s never a black-and-white solution. You’ll need a mix of investments—some that have the potential to grow over time (e.g., stocks) and some that are more conservative and help manage risk (e.g., bonds and money markets). There are long-term planning approaches, like the retirement income bucket strategy, that can help control emotions during stock market volatility.

If your current portfolio seems skewed to the extremes—mostly in conservative money markets or mostly in aggressive stocks—you might want to reevaluate your investment plan with the help of a financial advisor.

Are You Ready to Face What’s Ahead?

Your confidence should be the core of your investment plan. If market volatility is rattling your resolve, it may be time to reevaluate your current situation. Together, we can create a plan that takes all your needs into consideration and manages investment risk.