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About 9 minutes
While earning a return is the fun part of investing, it’s only half of the story. Which means we also need to talk about risk.
What is risk
Risk can mean different things to different people. But when it comes to your finances, it generally comes down to the possibility of losing money or not having enough money when you need it.
Sadly, we aren’t naturally great at understanding and managing risk, because our emotional minds like to interfere. When things are going well (or when risk is hard to conceptualize), we have a tendency to underestimate the danger, which leads us to let our guard down when we shouldn’t. Psychologists call this optimism bias.
Alternatively, sometimes the opposite is true, like during a stock market crash when fear runs amok. This fear can cause us to overestimate the true risk at hand. And we might be tempted to sell our investments at exactly the worst time instead of waiting it out.
Long story short, our emotions can lead us to make some bad financial decisions, particularly when it comes to estimating risk. So it’s important to have a realistic understanding of what financial risks are out there and to take steps to manage them.
While some risks can be covered by an emergency fund, and others can be covered by insurance, when it comes to investing, there are two big risks you’ll want to be aware of; market risk and inflation risk.
When you invest your money in individual stocks and bonds, you’re putting it at risk of those particular investments going down in value.
Sure, we usually expect stocks to go up and bonds to pay interest. But it just doesn’t always work out that way. Any given investment can run into trouble and that means your money will be at risk. Let’s say you own the stock of a company that goes out of business, you could end up losing your entire investment. Concerning, to say the least.
But there is hope. As we mentioned in the section on diversification, you can reduce this risk by diversifying. This means spreading your money across multiple investments, which you can do fairly easily by investing in funds.
Phewww, no need to worry anymore. Right? RIGHT?!? Not quite.
Even if you diversify, stocks as a whole can still drop in value. And THIS is what’s referred to as market risk.
When you invest in stocks, bonds, and other financial assets, their prices will fluctuate. These fluctuations depend on how much buying and selling occurs in financial markets. So if you need to sell your investments, you’ll be at the mercy of the market.
And as it turns out, different investments tend to fluctuate more than others. These are said to be more volatile (or have higher volatility). For the most part, stocks tend to be more volatile than bonds, and real estate is usually somewhere in between.
But, with higher market risk comes higher reward. In fact, there’s a direct relationship between market risk and return. Investments that have higher market risk (i.e. they fluctuate in price more) tend to earn higher returns over time.
Higher market risk (more volatility) = higher returns over time
Market Risk extremes
So how bad can things get investing in stocks?
Without a doubt, the worst period for stock investors in the last hundred years was the 1929 stock market crash, which was then followed by two years of continued declines and the Great Depression.
Leading up to the crash, the stock market had tremendous gains throughout the Roaring Twenties. This resulted in unbridled investment confidence and instant riches for the daring. But all good things must come to an end, and end they did. From the high point in 1929 to the low point a few years later, the market lost roughly 90% of it’s value.
Think about that for a second. If you had invested $100,000 at the peak in 1929, your investment would have fallen to about $10,000. And, what’s equally frightening, stocks didn’t return to their peak until the 1950s, more than twenty years later.
Less extreme extremes
Okay, admittedly the crash of 1929 was an extreme and rare occurrence. After all, we’re still talking about it all these years later. And while something like it could certainly happen again, trying to plan for an event like this will make it virtually impossible to take on any investment risk at all. And that’s not a realistic plan for most of us.
However, there have been other, less extreme, yet painful periods for investors.
In 1987, on what’s now know as Black Monday, the stock market lost over 20% of it’s value in a single day. Harrowing. And during the fall of 2008, markets declined by roughly 50% over the course of several months, sometimes dropping by more than 5% in a one day. Stocks recovered fairly quickly (within a few years) after both of these events, but there’s no guarantee that will always happen.
Starting in 2000, the bursting of the dot-com bubble caused the stock market to lose roughly half of it’s value over several years, with technology stocks faring significantly worse. The S&P 500 didn’t recover it’s peak value until 2007, which was shortly thereafter followed by the 2008 crash. Many technology stocks never recovered.
Additionally, smaller drops and crashes happen more regularly.
Bear markets (which are defined by a market decline of 20% or more) tend to occur every few years. Market corrections (a drop of 10% or more) occur about once a year on average. And daily declines of 1% or more are fairly common.
So given the possibility of large declines in stocks prices, what should you do, if anything?
Diversifying across asset classes
In the same way you can create a portfolio of multiple stocks, you can go one step further and create a portfolio of multiple asset classes (stocks, bonds, real estate, cash).
Why does this work? Well, sometimes the prices of stocks will be going down while the prices of bonds or real estate are going up, or vice versa.
Or, if they are all going down, the prices of bonds might not go down as much as the prices of stocks. As long as their price movements aren’t moving in perfect lock-step with one another, you’ll do better by diversifying.
In the next section, Investing Portfolios, we’ll cover how to create the right mix of assets for your portfolio.
Okay, it sounds like stocks can get into some pretty rough patches at times. So why not just invest in safer assets like bonds?
For one, as we mentioned, stocks tend to offer higher returns. So if you’re going to be investing for a while, the higher returns can outweigh the added risk. The longer you’re investing for, the bigger the benefit.
Also, investments with higher market risk, like stocks, tend to do a better job of protecting you against inflation risk. Over time, inflation erodes the value of your money, even money you’ve invested.
Market risk seems to get a lot more coverage than inflation risk in the financial press. This is partly because it’s more noticeable. When the stock market drops by 10%, people notice, and news outlets can publish articles describing the agonizing details.
But when inflation slowly erodes several percentage points off your wealth every year, it’s hardly a newsworthy event. Often it goes completely unnoticed. However, the consequences can be just as severe over time, so it’s important to manage the risk.
Protecting against inflation risk
As we mentioned, certain assets tend to do a better job keeping up with inflation. It’s a good idea to make sure at least some of your money is invested in them.
Stocks and real estate, for example, represent ownership in physical, or real, entities (ownership of a business with stocks and ownership of property with real estate). These tend to rise in value as inflation rises. So their returns tend to do a better job keeping up with inflation over time.
Bonds and cash, on the other hand, represent paper contracts. A bond is an agreement to repay borrowed money. And cash represents a claim on a financial deposit at a bank. Since there’s no physical asset backing them up, they’re less protected from inflation.
Side Note: There is a special kind of Treasury bond called TIPS (Treasury Inflation-Protected Security) that is intentionally designed to keep up with inflation by adjusting the principal amount over time based on inflation, but this is a special case.
Inflation Risk vs Market Risk
Since stocks tend to earn a higher return over time AND tend to do a better job keeping up with inflation than bonds, it might be tempting to invest all of your money in stocks. But you don’t want to forget about market risk. As we discussed, stocks tend to fluctuate in price more. And this can be a problem if you need to access your money in the near future and prices have declined.
Which brings up an important trade-off between market risk and inflation risk:
Investments that tend to have less inflation risk, like stocks and real estate, tend to have more market risk.
Investments that tend to have less market risk, like bonds and cash, tend to have more inflation risk.
So as you create and manage your portfolio, you’ll want to think about your market risk tolerance and your investment horizon. But you’ll also want to consider the balance between market risk and inflation risk. For most of us, this means having a mix of both kinds of investments.
Balancing long-term and short-term
You can also think of inflation risk as being a long-term risk and market risk as being a short-term risk.
From one year to the next, inflation is unlikely to have a huge impact on your investments (as long as inflation rates are relatively low). But, over the long run, inflation will have a big impact.
Market risk, on the other hand, can have a big impact on your portfolio in the short term (think stock market crash), but over longer periods, the short-term fluctuations won’t matter as much.
This is why it’s generally recommended to hold more stocks if you have a long investment horizon (meaning you are investing for a long time period) and to hold more bonds if you have a shorter investment horizon.
Which, as it just so happens, brings us to our next topic, Investing Portfolios.
1) Risk is about uncertainty of future events, and financial risk is about the possibility of not having enough money when you need it.
2) While some financial risks can be handled with an emergency fund and insurance, your investments will have some amount of market risk and inflation risk that should be managed with your portfolio.
3) Investments that tend to have more market risk (fluctuate in price more), like stocks, also tend to offer higher returns over time. Investments that have less market risk, like bonds, tend to offer lower returns over time.
4) Stocks and real estate, which represent ownership in physical entities, tend to do a better job protecting against inflation risk than paper contracts, like bonds and cash.
5) You can think of market risk as a near-term risk and inflation risk as a long-term risk. If you’re investing for the long term, you can generally accept more market risk (can hold more stocks) and if you’re investing for the short term, you can generally accept more inflation risk (you can hold more bonds).
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