Investment Risks: What You Don’t Know CAN Hurt You
I’ve noticed a couple common threads in investment planning conversations across investors of various experience levels and account balances.
- Many people don’t understand how their bonds lost so much last year. “Aren’t bonds supposed to be safe?”
- Others don’t understand why they would put any money in international stocks, when domestic stocks perform so much better? Or invest in the entire U.S. market when the S&P 500 performs better? Or an S&P 500 fund when tech stocks perform better? Or any fund at all, when a single stock, or collection of stocks they own or have been watching has performed better?
So let’s take a look at the different risks that any investment portfolio should address, how different assets address and expose you to different risks, and unique risks we face as we approach and navigate retirement.
Volatility ≠ Risk
We often use the standard deviation measure synonymously with investment risk. Standard deviation (SD) is the measure of total risk. It tells us how much variance there is around an expected return; in other words, how volatile or unpredictable an investment’s returns are.
It is important to understand SD. However, there is far more to understanding an investment’s risk than knowing its SD.
Higher risk, as measured by SD, tends to correspond to higher rewards. So an approach that is overly focused on lowering SD, can set you up for an even bigger risk….not achieving your financial goals.
We need a more nuanced understanding of risk. What are the components of risk and how can we mitigate each while still achieving our goals? Let’s look at a few of the biggest risks a portfolio faces.
Unsystematic (Diversifiable) Risks
Let’s start with a few unsystematic risks of stocks. These are risks that can be diversified away, yet a surprising number of portfolios I see fail to do so.
Diversification is psychologically hard, because it guarantees you will never have the optimal portfolio. Some stock, asset class, concentrated fund, part of the world, etc. will always be doing better than your diversified portfolio.
The flip side of that coin is that your diversified portfolio guarantees that you will never have the worst performing portfolio. Something you own will always be performing relatively well.
The latter is far more important than the former. Our first goal is to stay in the game, because these are asymmetric rewards vs. risks.
It would be nice to hit a home run with our investments and become incredibly wealthy. We absolutely cannot afford to get wiped out by taking unnecessary risks. This is especially true as we approach and navigate retirement.
Business, Regulation, and Sector Risk
Business risk is the risk that an individual company may underperform expectations or even fail. We recently witnessed Silicon Valley Bank go from one of the largest banks in the country to bankrupt in a matter of days. Historically, even behemoths like Enron and Lehman Brothers quickly went from billion dollar companies to worthless.
Sector risk is the risk that one sector of the economy such as tech, healthcare, or energy will perform particularly poorly. This can be due to regulatory changes, general economic factors, or innovation that disrupts the status quo.
It’s common for people working for “great companies” or who “know their industry” to overweight their investments towards those companies and industries. They feel their knowledge provides an advantage over other investors. While this could be true, it is also possible that this could lead to overconfidence. Humility is our friend as investors.
Overweighting towards the company you work for or the industry in which you work absolutely increases the risk that a business downturn can negatively impact your income source and investment portfolio simultaneously.
You can diversify away business, regulation, and sector risk by investing in a broadly diversified index fund or ETF like an S&P 500 or total market fund.
A common pattern for people all over the world is home country bias. That is to invest predominantly or entirely in assets from your home country.
Americans will point out that this isn’t as big of a risk for us, because the U.S. represents nearly 60% of the global equity market. While true, this is another way of saying ignoring international markets is to ignore over 40% of the total equity markets.
As noted in the introduction, a lot of people are currently questioning whether it is necessary to invest in international markets at all. U.S. stocks have dominated international stocks over the past 15 years. While true, this is short sighted and misses extended periods where the opposite was true.
For Americans, a home country bias is not totally unreasonable. There are compelling reasons to not hold international stocks. However, it is vital to understand the risk this adds for extended periods of underperformance and the need to be willing and able to stick with your strategy through those periods.
New investors who think they only need American stocks based on recent performance may be buying at inflated prices near the end of a cycle that is about to switch. Even more harmful are people who have held international stocks through a period of underperformance and are ready to give up on them right before it may be their time to shine.
At the end of the day, no one knows with certainty what the future holds. My crystal ball is no better than yours. But if history is any guide, a globally diversified portfolio will pay off over time. Whichever approach you ultimately choose, you must do so with the conviction to stick with it through inevitable periods of underperformance.
Diversifying Away Risk
You can diversify away a lot of risk holding just two funds, a total U.S. stock market index and a total international stock market index.
Related: Is The 3 Fund Portfolio Right For You?
For someone early in their accumulation mode and with the stomach for a bumpy ride, this may be all you need. However, those bumps can be pretty large. This leads to our next risk that must be clearly understood….
Looking at data for VTSAX as a proxy for the total U.S. market reveals a standard deviation of 18.33%. Using VTIAX as a proxy for non-US stocks reveals a standard deviation (SD) of 20.73%. To use a nice round number, let’s call SD of broadly diversified markets 20%. What does this mean?
Let’s assume a normal distribution of stock market returns (i.e. bell shaped curve) and that stocks will return about 10% annually with about a 20% SD. You will rarely ever have a year with a 10% “average” return. Instead returns will tend to play out as follows:
- 68% of the time you can expect your returns to fall within +/- 1 SD, or between -10% and 30%. 34% of the time you can expect returns of -10 to 10%.
- 95% of the time you can expect returns to fall between +/- 2 SD, between -30% and 50%. 13.5% of your returns can be expected to fall between -10% and -30%.
That is a lot of variability before we even get to the real outlier events! Depending on the length of your investing timeframe, you should assume your stocks will drop by about 50% at least once.
For accumulators, those big market downturns can be your friend. They allow you to buy more shares for the same amount of money. But that only works if you are willing and able to keep buying.
For retirees and those nearing retirement who don’t have the ability to wait for markets to recover, this market risk can destroy your plans. This is why we need to diversify beyond stocks to avoid our next two risks….
Sequence of Returns and Liquidity Risk
Sequence of returns risk is the risk that you will have a large market crash or a prolonged period of low returns early in retirement. If you have to take portfolio withdrawals while the portfolio is depressed in value, the portfolio may be depleted to an extent that it will be unable to recover in time to last through your entire retirement. For a comprehensive discussion of sequence of returns risk, I recommend this resource from Early Retirement Now.
Liquidity risk is the risk that you can not create the cash necessary to meet your financial obligations. While a widely traded total market mutual fund or ETF is liquid in that you can sell it and have cash in hand within a few days, their volatility means that you may have to sell at depressed prices.
We need to have a portion of our portfolio in assets that are truly liquid to address these two risks. This means you can access cash when you need it AND at a predictable price. Cash or cash equivalents (high-yield savings accounts, money markets, treasury bills or funds, short-term CDs, etc.) fill this role in a portfolio.
Why take any risk? Why not keep all of your portfolio in ultra-safe liquid assets? Because they expose you to our next risk….
Purchasing Power (Inflation) Risk
Inflation risk is the risk that inflation will increase faster than the rate of return of your portfolio. In practical terms, this means that the dollars you have today will have less purchasing power in the future due to the impacts of inflation.
A reasonable goal for cash or cash equivalents is to keep pace with inflation. Outpacing inflation with cash investments over long periods of time is unlikely. Getting a higher rate of return typically requires investments with more risk.
This is why we should consider bonds with longer maturities in our portfolio. If you can get more yield with longer bonds, why have cash at all? As many investors learned over the past year, intermediate and long term bonds expose us to yet another risk….
Interest Rate Risk
Interest rate risk is the risk that interest rates will rise causing your bond values to fall. This may be counterintuitive at first, but a simple example should clarify.
Imagine buying a $1,000 bond today paying 5% interest, or $50/year. Tomorrow rates go up, and the equivalent bond pays 6%, or $60/year. If you have to sell your 5% bond, it would be hard when someone could buy a brand new bond paying 6%. So you would have to sell at a discount.
How far bond values will drop for a given rise in interest rates is a function of the bond’s duration. The longer time you have until your bond matures and can be reinvested at the new higher rates, the greater the value the bond drops if you need to sell it.
Related: How Low Can Your Bond Values Go?
For that reason, we would want to keep the duration of your portfolio less than or equal to the amount of time you have until you may need the money.
Interestingly, we are currently in an unusual period where short-term interest rates are actually higher than long-term interest rates. With so many of us suddenly aware of the impact of rising interest rates on longer duration bonds, a logical question arises: Why not just keep all of your investments in cash equivalents that don’t have interest rate risk?
The answer leads to our next risk….
Reinvestment risk is the risk that interest rates drop and you have to reinvest at lower rates as your bonds mature.
Imagine the same scenario as above with one difference. Instead of rates going up by 1%, this time rates drop by 1%. Your short term bonds will soon mature, and you will have to accept a lower yield on newer bonds when you reinvest.
If you were holding a bond with a longer maturity, you would keep collecting your higher yields until it matured. In addition, when rates drop, the value of your old higher yielding bond goes up. So if you needed to raise cash by selling the bond, you could sell it for greater than its face value.
Keeping all of your bond investments short-term may have made sense a few years ago when the world was coming out of the pandemic. Interest rates were at all time lows and the risk reward profile of longer term bonds made little sense.
Doing so now feels like fighting the last war. After a rapid increase, interest rates are approaching historical averages. We don’t know where they will go from here, so build your portfolios in a way that will work reasonably well without having to predict the future correctly.
All of this discussion about interest rates ignores another big risk of bonds that needs to be mentioned….
A bond is a debt instrument. You are lending money to a company or government entity. They are agreeing to return your capital at a defined point in time and pay interest on your cash in the interim.
As noted above, one way to traditionally command a higher return is to loan your money for longer periods of time, which increases interest rate risk.
The other way to get higher yields is to loan your money to less qualified borrowers. This increases default risk, the risk that the borrower will not be able to return your money.
There are several ways to limit default risk. If you choose to invest in riskier bonds, you should do so in a bond fund where you can diversify away the risk of holding just a few bonds that could cause serious harm if one or a few defaulted.
Alternatively, my preferred approach is to limit this risk by investing only in high quality bonds with little default risk. U.S. treasury bonds allow you to essentially eliminate default risk.
However, as with all risks this is a tradeoff. You have to accept lower yields and potentially the need to then take more risk elsewhere in your portfolio to achieve your goals.
Putting the Pieces Together
When building my portfolio and helping others build theirs, I think about every investment dollar having a role, focused on achieving the required investment returns with the minimum amount of risk.
Start with the foundation. This is to have enough liquidity to meet your spending needs.
- For accumulators with large positive cash flows and few liabilities, this may be very little.
- For retirees, having a few years of spending needs held in short-term investments (some combination of high-yield savings, money markets, T-bills, CD’s, bond or CD ladders, etc.), is prudent to meet spending needs through most run of the mill bear markets.
Related: The Next Bear Market — How Bad Could It Get
Next consider how much money you’ll need to allocate to intermediate term bonds. They provide a source of income and stability. (Some people like long-term bonds for traditionally higher yields and better diversification in times of dropping interest rates. I personally avoid them.)
- For accumulators, the amount will be determined by your risk tolerance and can vary considerably.
- For retirees, a good goal is to have a total of 10 years of expenses in fixed income assets allowing you to ride out all but the worst bear markets for stocks. Depending on how much is allocated to short term debt instruments, you can fill that bucket with intermediate term bonds. More conservative investors with larger portfolios may want to allocate more money to bonds.
Finally, consider how much risk you are willing and able to take with stock investments. Allocate your dollars between U.S. and international funds focusing on low-cost, tax-efficiency, and broad diversification.
- For accumulators with a high risk tolerance and long investing timeframe, this can be the vast majority if not all of your investment dollars aside from any cash savings.
- For retirees and those approaching retirement, the amount you allocate to stocks will depend on the size of your portfolio and your tolerance for risk.
* * *
- The Best Retirement Calculators can help you perform detailed retirement simulations including modeling withdrawal strategies, federal and state income taxes, healthcare expenses, and more. Can I Retire Yet? partners with two of the best.
- New Retirement: Web Based High Fidelity Modeling Tool
- Pralana Gold: Microsoft Excel Based High Fidelity Modeling Tool
- Free Travel or Cash Back with credit card rewards and sign up bonuses.
- Monitor Your Investment Portfolio
- Sign up for a free Personal Capital account to gain access to track your asset allocation, investment performance, individual account balances, net worth, cash flow, and investment expenses.
- Our Books
- Choose FI: Your Blueprint to Financial Independence
- Can I Retire Yet: How To Make the Biggest Financial Decision of the Rest of Your Life
- Retiring Sooner: How to Accelerate Your Financial Independence
* * *
[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at email@example.com.]
* * *
Disclosure: Can I Retire Yet? has partnered with CardRatings for our coverage of credit card products. Can I Retire Yet? and CardRatings may receive a commission from card issuers. Other links on this site, like the Amazon, NewRetirement, Pralana, and Personal Capital links are also affiliate links. As an affiliate we earn from qualifying purchases. If you click on one of these links and buy from the affiliated company, then we receive some compensation. The income helps to keep this blog going. Affiliate links do not increase your cost, and we only use them for products or services that we're familiar with and that we feel may deliver value to you. By contrast, we have limited control over most of the display ads on this site. Though we do attempt to block objectionable content. Buyer beware.
Join more than 18,000 subscribers.
Get free regular updates from "Can I Retire Yet?" on saving, investing, retiring, and retirement income. New articles weekly.
Chris, this is excellent – a veritable investment primer and a good reinforcement for those of us that have some experience. Thank you!
Thanks for the feedback Tom.
Thanks for the dive into risk. I have been reading and studying quite a bit. On the bond front in early retirement I switched from a total bond fund to only US treasury bond fund(intermediate for my overall portfolio, short treasury MM for near term needs) . I also increased my allocation (20%) to International, although its still below the allocation many recommend. I found I needed to pick an allocation I can stick with long term. Small cap value has a 15% weight. So for me in early retirement its a 4 fund portfolio but that feels right for us. Some real estate and collectibles too but they represent under 20% of NW. considering increasing real estate. Haven’t decided.
I appreciate you sharing these details. I think this is where a lot of people get hung up. My post focused on principles, but there are a lot of different tactical approaches (one of which you lay out) to build a “good enough” portfolio. All of them involve a degree of uncertainty and trade-offs b/t different risks and rewards, and so it’s easy to get stuck in paralysis by analysis.
I’m quickly learning in my role as a planner that a lot of people just want to be told what to do. That is frankly hard for me, because as I noted in the post, I don’t have definitive answers any more than they do. So I try to educate as much as possible, point out any blind spots and red flags clients may have, and emphasize that at the end of the day only the person whose money is invested has to live with the consequences, so final decisions have to be theirs.
What a nice thorough breakdown. I like that you resist giving easy answers like a lot of bloggers and readily pointing out how all investments have a risk. It’ll be interesting to see if treasuries will go back to the low rates we have all become too accustomed to. Id love to dump more money and low risk assets if I could get treasuries north of 4 or 5%. Guess time will tell.
Thanks for the feedback. We’d all love to know where rates and markets are going! As you say though, time will tell so we need to have plans that aren’t dependent on our predictions.
Did you ever explain why bonds lost so much? That’s why i read the article, but you put so much info in there that my eyes glazed over after a while. thanks for all the info, but in one article, I just could not absorb it all.
Look under the interest rate risk section. 🙂
I consider myself a fairly savvy investor, but the drop in bond funds caught me off guard too. Appreciated Chris’s clear explanation.
Joe for more detail you can follow this link that I included: https://www.caniretireyet.com/bond-duration/
I am hoping you can explain even the rationale for having bonds in your portfolio as somebody who is retired. They used to have a negative correlation to stocks so it was reasonable to assume when stocks were down, your bonds would not be and they could be a source of cash/spending during that time. Recently (2008 crash to today), they seem to have lost the negative correlation and are essentially lower yielding stocks. So if that is true, what is their purpose in a portfolio for a retired person?
I appreciate this question. It is a conversation I find myself having frequently that prompted this post. I get the sense that you don’t understand two things:
1. Sequence of returns risk and the risk volatility presents.
2. The potential volatility of stocks vs. bonds. Last year, both went down by about 15%, so many people have taken the posture that you have. Why have bonds if stocks go down at the same time and can go down by just as much?
However, this is where understanding standard deviation as a risk measure is important. The 15% loss in stocks is barely outside of being a 1 SD event. This should happen 1-2x every decade statistically. You should absolutely expect these types of returns and if they are too much to stomach, then you are overexposed to stocks.
In this article Allan Roth explained that last years losses for an aggregate bond fund in 2022 were “5.5 standard deviations, which should happen once every 50 million years.”
As I wrote here in May 2020, bonds had a horrible risk-reward relationship coming out of the pandemic with rates near 0%. The idea that they could be counted on as a diversifier as we’ve all gotten used to over most of our investment lifetimes was likely naive. However, if you reread that article now, I think you’ll agree that bonds at least have the potential to play all three roles they traditionally have played in a portfolio.
I hope that helps illustrate the difference in volatility and why bonds are in portfolios, particularly for retirees.
This was an excellent article! It very concisely addressed the major investment risks and summed up a lot of things also written about in that the wonderful old book “A Random Walk Down Wall Street”.
Thanks for the kind words Rich,
Risk is one of my favorite topics to think and write about, with regards to investments and personal finances, outdoor adventures, and life in general.
Diversifying risk will lead to an “optimal” portfolio that achieves the best balance between risk and reward. The article mistakenly uses the word optimal to mean “best performing” (para 2 in the section on unsystematic risk). However, the idea is valid in that the optimal portfolio is almost never the best performing portfolio.
Thank you for keeping me sharp with my choice of words. You are correct!
Comments are closed.