Everyone would agree that it is impossible to predict future stock market returns. Investment models can produce hypothetical returns but they clearly can’t account for future events. So, investors who manage their investments based on market performance or what they perceive as opportunities for better returns have very little control over the outcome.
On the other hand, risk is a certainty. There will always be market risk, interest rate risk, inflation risk and taxation risk. If your investment portfolio is not vulnerable to market risk it is most likely vulnerable to interest rate or inflation risk. We also know that, over the long term, taxes can impede returns and portfolio performance. If it were possible to control the risks to your portfolio, then you could improve the long term performance of your investments.
Understanding all Risks
Most investors understand the concept of risk and reward – that, in order to achieve higher returns, you have to be able and willing to assume a commensurate amount of risk. So, investors who seek an annual return of 25% on their investments should be able to tolerate a higher amount of risk than the investor who is satisfied with a 5% annual return. The risk of loss associated with the stock market is called “market risk”.
Many investors who were rattled from the steep declines in the market during the 2008 crash, and more recently in the August 2011 plunge, have decided they have little tolerance left for market risk, and many of them have moved their money to “less risky” investments, such as Treasury securities or low yielding cash vehicles. The problem for these investors is they have now left their portfolio vulnerable to other adverse risks. Effectively managing all of your risks entails allocating your investments along a mix of assets that can act as counter-weights to the various types of risk.
There is always going to be inflation. In recent years, inflation has been very low, but there have been bouts of extremely high inflation, well into double digits. When there hasn’t been inflation, there has been deflation or stagflation, which some would consider to more dangerous conditions for investments. When investors shift their assets to low yielding or fixed yield investments to avoid market risk, they are exposing them to inflation risk.
It might seem like the prudent thing to do to move your money into a CD earning 3% with absolutely no market risk. But, if inflation were to average 4%, your assets would lose 1% of their value. Lower yielding savings or investment vehicles can’t keep pace with inflation over the long term, and the steady erosion of purchasing power is no different than suffering a loss in the stock market. It is vital to always have a portion of your assets diversified among inflation risk investments.
Inflation risk investments: Large, blue chip stocks of multi-national companies; TIPS (Treasury Inflation Protected Securities); real estate, gold or silver
Interest Rate Risk
We also know that interest rates will rise; and they will fall. Unlike changes in the direction of the stock market, changes in interest rates do come with some forewarning. For instance, when the economy slows down as it has these last few years, the Federal Reserve will lower interest rates to try to stimulate economic activity. Conversely, when the economy begins to overheat, the Feds will increase rates to try to contain inflation. Generally, when interest rates rise, the prices of debt securities decrease, and in a declining interest rate environment their prices will increase.
People who stash their money in fixed yield vehicles are also vulnerable to interest rate changes. If you lock your money into a five-year CD at a rate of 3%, and interest rates rise over that period, you have lost the opportunity to earn a higher return. Similarly, if interest rates decline over that period, you will likely have to roll your money into a lower yielding CD.
Interest rate risk investments: Dividend-paying stocks, market adjusted CDs,
Nothing except death is more certain than taxes. At one time or another, the IRS will collect its share of your investment earnings. But, as imposing as the tax code is, it does allow investors to use all legitimate means to minimize and even avoid taxes. Deferring taxes, which can be done using qualified retirement plans and annuities, enables your earnings to compound unimpeded by taxes so they can accumulate more quickly; however, there is usually a tax consequence when you eventually access those funds. Understanding investment taxation, such as capital gains, loss carry forward, investment income, etc., is critical to maximizing the long term growth of your assets.
Taxation risk investments: Tax exempt bonds, annuities, qualified retirement plans, college 529 savings plans, tax-efficient mutual funds, index funds, ETFs, REITs.
The most effective way to manage and minimize all investment risk is through the broad diversification of assets under a long-term investment strategy. Investors should always consider their long-term objectives and overall tolerance for risk when selecting investments.