How Do YOU Define Risk?
By: Bryan J. Koslow, MBA, CFP®, CPA, PFS, CDFA™
How Do YOU Define Risk?
Risk is a fundamental component of investing yet it is one of the most difficult concepts to explain. According to Merriam-Webster’s dictionary, risk is “the possibility that something bad or unpleasant will happen.” Investors face a number of risks, including:
- “Cocktail Party” risk – the risk that your portfolio performance won’t keep up with the performance of your friends’ portfolios OR the risk of not owning “popular” investments (i.e., dot com stocks in the late 1990’s, biotechnology stocks in recent years, etc.)
- Volatility risk – the risk of sharp moves in the value of your portfolio
- Absolute risk – the risk of any decline in the value of your portfolio
- Benchmark risk - the risk that your portfolio may underperform a benchmark such as the S&P 500 or the Barclays Capital Aggregate Bond Index
- Purchasing Power risk – the risk that the return on your investments may not keep pace with inflation
- Liquidity risk – the risk that you may not be able to turn your investments into cash in a timely fashion or at a price that you are comfortable with
- Interest rate risk – the risk that your investments lose value as interest rates rise or fall
- Credit risk – the risk that the issuer of debt instruments may default on their obligations
- Tracking error risk - the risk that an exchange-traded fund’s (ETF's) performance may deviate from the performance of the index it is supposed to track
Cocktail Party risk (a term we coined) is one of the most dangerous. Chasing the bandwagon or investing based on what others are doing often leads to bubbles that don’t end well. It can also lead investors to purchase things they may not fully understand and/or that may not align with their investment objectives or risk tolerance.
While the risks above are very real, we find that many of our clients are more concerned with financial planning risks, such as: (1) Will they be able to retire when they want to? (2) Will they outlive their assets? or (3) Will they have to apply for Medicaid to address long-term care needs? Fortunately, many of these risks can be managed with proper planning and responsible decision making. “Doing the basics” can significantly improve your likelihood of success. For example, maintaining a household budget; making conservative assumptions about returns, taxes, and life expectancy; and managing risk are time-tested ways to solidify your household financial situation.
We have found that clients can avoid unnecessary stress simply by eliminating some of the financial unknowns in their lives. For more information on the financial planning process, please contact us at [email protected].