Risk and return go hand in hand with investing. Risk is unavoidable. In order to generate returns, investments must carry some degree of risk. But not investing is also risky, as you take the chance of not having enough money to meet your financial goals. As the great Wayne Gretsky once said, “you miss 100% of the shots you don’t take,” and the same goes for investing. Since some level of risk is almost unavoidable, here is an overview of some common risks along with some methods that may help you manage your exposure to them.
Risk is the possibility that the value of an investment will decrease because of factors that affect the overall performance of the financial markets. A decline in the stock or bond markets will typically cause your portfolio holdings to lose value, too.
Market risk, also known as systematic risk, refers to the overall risk of being in the markets due to the day-to-day fluctuation in stock and bond prices in general. Recessions, wars, and changes in interest rates can all contribute to systematic risk because these events are likely to impact the entire market. Typically, systematic risk cannot be lessened through diversification alone, but other strategies, such as hedging, may be useful in reducing this type risk.
On the other hand, idiosyncratic risk is specific to a firm or industry, and this type of risk may be minimized through diversification. This can be done by distributing your investments among different stocks, bonds, and cash, as well as other types of investments. Through diversification, you increase the chances that a downturn in one security, asset class, or sector that you hold in your portfolio may be offset by other investments that you own.
Still another prudent method of mitigating risk is through diversification by factors.* The elemental sources of risk premiums and expected returns, academically derived equity factors include value, quality, momentum, size and low volatility, while within fixed income, investors can target the return premia associated with interest rate risk, and credit risk. Given it’s nearly impossible to predict if and when a given factor will contribute positively to a portfolio’s return, by diversifying across multiple factors, investors have the opportunity to capture some of the return potential of those factors that are currently in favor, without being overly exposed to those that may be detracting from the portfolio’s return.
Interest Rate Risk
Bond investments carry risk due to the fact that they are mainly affected by rising and falling interest rates. Generally, existing bond values decline when interest rates rise due to the fact that newly issued bonds offer higher rates thereby making them potentially more attractive investments. Investing in a variety of bonds with varying maturity dates (individually or through a fund) can help you manage some types of interest-rate risk, as can investing in bonds from other nations. Investors can take more or less interest rate risk depending on their willingness to endure losses in their bond portfolios.
Impact of Inflation
Inflation inevitably takes a toll on the purchasing power of your money over time; even low inflation rates over many years may significantly raise prices, reduce your purchasing power, or restrict your lifestyle in the future. One method that may be used in managing inflation is to choose investments with the potential to produce long-term returns that will hopefully keep pace with, and possibly exceed, the rate of inflation.
Along with an understanding of various types of risks is a realistic understanding of your ability and willingness to stomach market volatility. Both you and your advisor should work together to assess the proper amount of risk you should take based on your individual situation, and long-term financial goals.
Apella Capital, LLC has an arrangement with its affiliate, Symmetry Partners, LLC, under which Symmetry makes model portfolios available to Apella for use with Apella’s clients. For additional information regarding the relationship between Apella and Symmetry, please see Apella’s ADV Part 2A located on the Apella website at www.apellacapital.com.
*Symmetry Partners’ investment approach seeks enhanced returns by overweighting assets that exhibit characteristics that tend to be in accordance with one or more “factors” identified in academic research as historically associated with higher returns. Please be advised that adding these factors may not ensure increased return over a market weighted investment and may lead to underperformance relative to the benchmark over the investor’s time horizon. The factors Symmetry seeks to capture may change over time at its discretion.
Apella Capital, LLC, is an investment advisory firm registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted. No current or prospective client should assume that future performance of any specific investment, investment strategy, product, or non-investment related content made reference to directly or indirectly in this article will be profitable. As with any investment strategy, there is a possibility of profitability as well as loss. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Apella Capital or your advisor. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.