No investment is without risk. You may feel safe when you do what financial advisers consider the “right thing” — invest in a broad stock market index fund with a long-term view — but there is risk there as well.
Unfortunately, to build wealth over time, investors need to accept a significant amount of risk. Leaving money in risk-free investments, such as high-yield savings accounts, isn’t really investing at all. By taking on very little risk, keeping the bulk of your wealth in a savings account practically guarantees you’ll lose purchasing power over the long term due to the rising costs of goods that you might buy with that money.
Most middle class investors will need to grow wealth, rather than just preserve it, if financial independence is their end goal. So, just know that if you’re interested in growing your wealth over long periods of time, you’ll need to consider riskier investments than savings accounts.
Different Products, Different Risks
There is a dizzying selection of investment types scattered across the entire risk spectrum. These range from money market funds (low-risk investments, similar to savings accounts) to complex financial derivatives (risky financial moves often best left to professional investors).
Anyone who has ever invested in a 401(k) plan has had the opportunity to be familiar with risk profiling. To help you design your retirement portfolio, most 401(k) managers allow you to select your investments based on your appetite for risk. By asking the investor several questions about how they would react to different levels of investment performance, these 401(k) tools will categorize the investor based on their own, personal risk tolerance: usually low, medium, and high.
Measuring and evaluating the risk involved in any investment is a little more complex, though. While an investor’s risk tolerance can be categorized or marked on a scale, an investment’s risk should be plotted using several dimensions. To evaluate an investment, you should consider the different types of risk that could affect its performance in order to determine whether the investment is appropriate for you.
Resource: How to Evaluate an Investment Portfolio
Market risk
Market risk considers a broader picture. If you are invested in stocks, particularly if you choose the less expensive (but not necessarily safer) route of investing in a broad stock-based index fund, you have to accept that the overall economic condition of the country — or even the world — will cause your investment’s value to fluctuate. Market risk is relevant also for investments in single companies, bonds, or other products.
A market crash or decline could crush this investment’s performance, even if the quality of your investment remains the same. Investments also follow trends. For several decades, real estate could appear to be a “good” investment, encouraging more people to buy real estate and driving up prices for everyone else. Once the overall sentiment of investors switches to the belief that real estate is overpriced, your property could lose potential value… even though the structure hasn’t changed.
Learn More: 3 Keys to Deciding If Your Real Estate Is a Good Investment
Default risk
Default risk is related to the quality of the underlying investment, and is more apparent when investing in a single company through stocks or bonds. If you invest in a company’s or municipality’s bond, you generally expect a guaranteed return. The promised return is usually higher than what a savings account would provide, but you face the risk of default. If the company files for bankruptcy or if the municipality is mismanaged, it’s possible you won’t receive the return you were promised.
Pensions, thought to be stable investments for retirements, are also exposed to default risk. Today, your company may be promising all retirees access to free health care, but if your company later restructures, that promised benefit might disappear. The government offers a type of insurance for companies that offer pensions, but sometimes that insurance isn’t enough to ensure all pensioners receive exactly what had been promised.
Inflation risk
Financial planners like to assume that inflation runs about 3 or 4 percent a year over long periods of time. This allows planners and investors to calculate the expected “real” returns for an investment. If you assume inflation is 3 percent and your savings account earns 1 percent APY, your real return is a loss of 2 percent a year. This real return takes the effect of inflation into account.
There is a chance, however, that during any particular time, the measure of inflation — or for a more accurate description in this case, the increase of the cost of goods — is significantly more than 3 percent. If the country were to enter a period of hyperinflation, investments in your savings account would result in devastating losses when compared to consumer prices. (At least until banks began to offer more appropriate interest rates.) When a gallon of milk costs $25, a gallon of gasoline costs $30, and a movie ticket costs $75, it will be much harder to get by on the same income you had with today’s prices.
Mortality risk
Consider mortality risk when you have or are considering investments in pensions, insurance contracts, annuities, or any investment with a long-term horizon.
Annuities are the best examples. If your annuity payments or distributions to you continue only as long as you’re alive, you run the risk of dying before you receive enough of your benefit to make the premium payments and fees worthwhile. If your investment strategy focuses solely on the long-term, there is a chance that you will never live to enjoy the benefits.
Life is short. It’s almost always shorter than you would like for it to be. But realize that mortality risk runs in the opposite direction, as well. If you live longer than expected, and you have tried to plan your financial life so you fully expend your wealth during retirement, you run the risk of running out of money.
Related: Should You Take a Lump Sum for Your Pension?
Spend some time to think about the risks of your investments. You may discover that your tolerance for risk is lower or higher than you expected. Perhaps you’ll need to adjust to accept more risk in order to meet your financial goals.
Updated March 25, 2017 and originally published March 14, 2017.
{ 21 comments… read them below or add one }
I would also add “Liquidity Risk” to your list. If you are invested in things that like alternative assets, hard assets, real estate, collectibles or other investments that don’t have an active, liquid market then you might not be able to sell when you need the money, or even if you can, you might not get near the price you were expecting. And as these things tend to go, the markets for these items are least liquid when everyone needs their money.
David,
That’s a great thought. Liquidity risk is important to consider as well. Generally, most investments people consider a liquid enough, but once you start considering major ownership shares of a business, some insurance contracts, or other alternative or complex investments, liquidity could become an issue. Even for more standard investments like international equity index funds, liquidity could come at a cost. If you want to sell your investment within a few months, there could be a fee.
Liquidity is also a risk in real estate. It’s much easier to sell shares in a REIT than it is to unload a house when the housing market turns sour. REITs are less risky than an investment home in the sense of liquidity risk.
This is a nice overview. I’ve actively considered market, default, and inflation risk – but haven’t given much thought to mortality risk. But you’re right, it can be a factor to strongly consider. Along those lines, it would not be good to over pay for something you won’t live to cash in on, but even worse might be to be severely underfunded in old age.
I love this post!
I can’t believe how many people talk about “risk free investment” as if it’s a real thing. Even US Treasuries carry risk, but because so many people focus only on not losing money (in the nominal sense) they don’t think about things like inflation and devalued dollars.
You could look to Treasury Inflation-Protected Securities (TIPS) to reduce the inflation risk, though the real increase in prices could be much higher than the government-reported inflation rate used to set the TIPS rate. You also face opportunity risk — by investing a finite amount of cash in one vehicle, you could be missing better opportunities. Investor Junkie mentioned opportunity risk in an earlier comment… I’m just catching up now.
This assumes the government accurately reports CPI. While I myself own TIPS and I-bonds, I also have other investments not tied to the government accurately measuring something.
Well here you’ve hit upon the risk of TIPS.
But I used inflation as just one example of risks many people don’t consider. To many, “risk” is simply losing money when the stock market crashes and so they think that avoiding stocks is avoiding risk. Sometime, like early 2009, stocks are less risky than other assets.
That is why I like taking risk tolerance quizzes. Definitely helps you figure out where you stand.
I think risk tolerance quizzes are OK, but not perfect. It’s easy to answer on a quiz that you could withstand a short-term loss of 50% of your portfolio, but it’s another thing to truly experience that loss on paper and be faced with a real decision. The quizzes I’ve seen are simplified and don’t really put the investor in high-risk simulations, so the results are often more aggressive than the investor would actually be.
I think Mortality Risk is a big risk that a lot of people don’t take into account. If you have a pension (my generation doesn’t but older ones might) and it will only pay as long as you live what happens if your spouse outlives you? You better have a plan in place or else the income stream may completely disappear and devastate your spouse.
I don’t know why but the market seems riskier than ever lately. With the global economy, a problem anywhere in the world causes the market to plummet……and there is always a problem somewhere in the world. I get more discouraged by the day. If only CD rates were reasonable, I’d be running toward them.
Excellent post, I agree with the four risks you mentioned plus the comment on liquidity risk. One point about risk in terms of building a portfolio. Pairing investments that might by themselves be very risky together can actually lower your overall portfolio risk if the risk factors of these individual holdings are not highly correlated with each other. This didn’t work well in 2008, but it generally has over longer time frames.
Good post.
There is also opportunity risk. You are best putting your money to work in another investment that yields better returns.
http://investorjunkie.com/9033/risk-free-investment/
I didn’t include Mortality risk and that’s a good one to consider.
Thanks, IJ! Great point about opportunity risk. I should add that and liquidity risk to the article to edge it closer towards completion.
Though revisiting this post Flexo is mortality a risk? I mean we know we are going to die, that’s a fact. The question is when, not if. Maybe it’s a matter of syntax. It is really a risk of longevity, not mortality. I never considered it a risk for me personally, but there are certainly people I know that this will be an issue.
When I wrote my post I was thinking of external risks to your investing, not internal to myself. Meaning when I die there would be money left over.
I think of mortality risk as it applies to annuities contracts. Maybe longevity is a more accurate term, but I’ve seen this called “mortality risk” by financial planners. Mortality itself is a given, but the timing is rarely certain. Planning for the future requires making assumptions about longevity, which could prove to be wildly inaccurate. Buy an annuity, and you may die before receiving benefits “worth” the cost. That’s certainly a concerning risk. It’s less of a concern if you stick to investments not insurance contracts for growing your wealth, but it’s still something to think about.
Yea I’m not a fan of annuities in this current market. Why not roll your own? Do you have any discussions/posts about annuities? Especially strategies. It’s something I want to discuss more on my blog.
All of the comments are right on, certainly opportunity and liquidity risk are keys in addition to the four mentioned in the post. Longevity risk in my experience in dealing with near retirees who seek me out for a financial planning check-up and those who are my ongoing clients is THE key risk factor. At the end of the day the risk of outliving one’s assets is the main risk/fear for all retirees. This certainly plays into the construction of one’s investment portfolio. Take too much risk and you might incur out sized losses. Take too little risk and you might run out of money. I generally tell pre-retirees that the risk of outliving your assets is the greater risk in my opinion.
Great article, outlining the major risks with taking investments. I have an investment banker friend who strongly recommends putting 90% of their money in very safe investments like bonds, while putting 10% into the market.
Not many. I’ve largely stayed away from annuity topics because they can be overly (and unnecessarily) complicated and avoiding the topic has been easier. It’s something worth exploring more, though.