Writer William Faulkner said: "You cannot swim for new horizons until you have courage to lose sight of the shore." That's an eloquent way of expressing the inherent rewards in risk-taking. In investing, the willingness to take thoughtful risks creates the opportunity for you to build wealth over time. On the other hand, if you shunned all risk, you'd keep your savings under the mattress, where it would continually lose purchasing power due to inflation.
Even so, the risk of loss may have you feeling anxious about investing, or possibly unwilling to invest at all. Moving forward with a wealth plan doesn't require you to ignore risk or the associated anxiety, however. The opposite is true. Knowing more about risk helps you insulate yourself from the worst of negative outcomes. As a starting point, here are four basic investing risks and strategies for mitigating each.
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1. Market risk
Market risk is the possibility that some big-picture, external circumstance will negatively affect the financial markets as a whole. That circumstance could be war, a change in political regime, recession, or -- you guessed it -- a global pandemic. Whatever the instigating event, the effects can ripple across asset classes, industries, and geographies.
Market risk is the most unpredictable risk you face as an investor. It's also the most difficult to mitigate. A portfolio that's diversified across equities, debt securities, commodities, real estate, and cash will weather major external events better than a non-diversified portfolio; although all asset classes could be affected, at least they'll each respond slightly differently to market conditions.
You can also accept that you'll face market risk at some point in your investing career, and commit to riding out the resulting volatility. The history of the stock market shows this is your best strategy anyway. Even through wars, terrorist attacks, depressions, and recessions, the markets have always rebounded and shown growth rates well beyond what you can earn on cash alone. Since the late 1950s, for example, the S&P 500 has returned average annual growth of 8%. Cash yields in the modern era of low inflation and low interest rates only go as high as about 2%.
2. Business risk
Business risk refers to the potential for a company to fall short of its financial targets. Factors that affect business risk can be internal, such as poor management, or external, such as regulations, competition, or customer preferences.
As an investor, you are exposed to business risk by the effect it has on a company's share price. A missed earnings guidance or a muddled response to a new competitor, for example, could send the share price tumbling.
The simplest way to mitigate business risk is to diversify your portfolio. If no single company comprises more than 5% of your holdings, you won't be wiped out by a single bankruptcy. You can also avoid companies that are highly leveraged, younger companies that don't have a long-term track record of performance, and older companies that are slow to evolve.
3. Inflation risk
Inflation risk is the possibility that price increases will undermine investment returns. Fixed-rate bonds are susceptible to inflation risk. While these securities produce even cash flows over time, the purchasing power of that income declines as inflation rises. A bond with a coupon rate of 5%, for example, is more attractive when inflation is 2% and far less attractive when inflation is 6%.
And cash naturally loses value to inflation. Although current inflation rates are abnormally low thanks to the coronavirus, normal inflation rates are 2% to 3% -- which means the cash in your high-yield savings account is often losing value just by sitting there.
Diversification is the strategy here, too. Be thoughtful about how much you hold in cash and in fixed-rate bonds. Cash is important to have on hand to cover emergencies, and bonds may provide an important source of income for you. But you can complement these holdings with other asset types, like equities, commodities, and real estate. Another option is Treasury inflation-protected securities or TIPS, which are specifically designed for inflation protection.
4. Liquidity risk
Liquidity risk refers to the difficulty you might face converting a non-cash asset into cash. Penny stocks, for example, are notoriously illiquid -- because few investors are willing to buy them. But liquidity risk can take other forms, too. You might be reluctant to withdraw cash from a CD before the end of its term, because you'll be charged fees. Or you might not want to sell mutual fund shares at a loss after a market crash.
You can work around liquidity risk by managing investments according to your investment timeline. Any cash you expect to need within the next five years should not go into the stock market. Keep it in a high-yield savings account or CD instead. And as you near retirement age -- when you'll start taking regular withdrawals -- reduce the percentage of your portfolio that's invested in equities. Low-cost bond and income funds can pick up the slack.
Diversify, hold some cash, and ride it out
Diversification minimizes your exposure to business risk and inflation risk. And keeping cash on hand to cover immediate needs helps you manage liquidity risk. Market risk is harder to address, but diversification and cash-on-hand will help you there, too. That, along with the patience to ride out short-term turbulence, should keep you afloat as you head toward new financial horizons.
