My husband Todd Langford, a financial software developer and trainer, founder of TruthConcepts.com, says many investors look at risk all wrong. “They think higher risk means ‘hitting it out of the park,’ but actually, risk means ‘the likelihood of loss.'”
Chances are, you’ve taken risks that didn’t always go your way. Perhaps you have owned stocks, real estate, gold or some other asset that appreciated, but you failed to sell at the top (lacking that all-important crystal ball) and regretted it.
Author and CPA Thomas Corley, who spent five years studying the habits of millionaires, said in a recent Business Insider article that being “rich” comes down to just two things:
- Accumulating wealth, and
- Keeping the wealth you have accumulated.
Accumulating wealth usually happens through saving, investing, and living below their means through frugality, expanding their incomes, or both. According to Corley, 94% of those he studied saved 20% or more of their income for many years prior to becoming rich. Those with the most wealth had three more income streams. A few had inherited their wealth.
However, people can succeed with accumulation, then fail to keep the wealth they have accumulated! How many investors have suffered losses, major setbacks, or even lost it all? (Many… perhaps even you.)
If you were hard-hit by the Financial Crisis and haven’t radically changed your investment strategies, you have set yourself up for your next loss.
In this post, we explain 16 different types of risks that can subject investments to loss. We give you some questions to ask to reduce your risk, and we suggest strategies and investments which have proven reliable in a variety of economies and circumstances.
16 Types of Investment Risk
Market Risk, also called systematic risk, is the risk that virtually all securities or type of investments will be affected by economic or geopolitical events that can cause the whole market to decline. Systemic risk cannot be controlled by purchasing mutual funds or diversifying into different types of securities, as we saw in the Financial Crisis. Owning different asset classes (life insurance, real estate, life settlements, cash equivalents) does reduce market risk.
Business Risk, also known as unsystematic risk or sometimes capital risk, is the possibility a particular security such as a company stock will lose value due to challenges such as inadequate profits, labor strikes, increased competition, changes in consumer habits or government regulations that affect that industry.
Interest Rate Risk is a type of market risk. It is the possibility that rising interest rates will cause a fixed-rate debt instrument to decline in value. Bonds, preferred stocks, and other investments that offer a fixed rate of return are subject to interest rate risk.
Default Risk (also known as credit risk) is the possibility that the individual, company or municipality guaranteeing the return on an investment (stock, bond, mortgage or other contract) will not be able to honor their promise to pay due to bankruptcy or mismanagement.
Pensions, once thought of as a dependable source of income, are also increasingly exposed to default risk. As we have seen, companies can restructure and benefits can disappear or be altered.
Downgrade Risk is the risk that a bond may be downgraded by rating agencies, making it more difficult for the issuer to pay.
Credit Spread Risk is the possibility that the spread between the rate for a riskier bond and the rate for a more risk-free bond may vary after the purchase of the riskier bond.
Taxability Risk applies to municipal bond offerings and refers to the possibility that a security issued with tax-exempt status could potentially lose that status prior to maturity, which would cause bondholders to earn a lower after-tax yield than expected.
Increased Taxation Risk is the risk for anyone with tax-deferred retirement accounts (traditional 401(k), IRA, etc.) that income taxes will rise or investors will move into higher earning tax brackets, causing them to pay taxes at a higher rate when they take distributions. (BTW, we made up the term “increased taxation risk” because we could not find an official name for this risk, even though it is one of the biggest risks affecting many American investors today!)
Legislative Risk is the possibility that Congress could change the rules on securities or qualified retirement plans, “raiding” accounts through new taxes or other means. Such proposals have been heard in Congress multiple times over the years and have been enacted in other countries, according to Entrepreneur’s 2015 article by our friend Garrett Gunderson, “13 Reasons Why Your 401(k) Is Your Riskiest Investment.”
Call Risk is specific to bonds and refers to the risk a debt security will be “called” prior to maturity. Prevalent when interest rates are falling, it can motivate some investors to take on more risk to replace the same income stream.
Reinvestment Risk is the risk that falling interest rates will lead to a decline in cash flow from an investment when its principal and interest payments are reinvested at lower rates. It usually accompanies call risk, because the bondholder must find an investment that provides the same level of income for equal risk.
Inflationary Risk, or Purchasing Power risk, is the possibility that the value of an asset or income stream will be eroded as inflation shrinks the value of the dollar (or another currency). Investments that tend to have appreciating values and income streams—real estate, stocks, life settlement funds and whole life insurance—can help investors stay ahead of inflation.
Mortality Risk is the risk of dying too soon, or in some cases, “too late.” The former affects especially annuity contracts that deliver payments only while you are living and rely on a long-term investment horizon. And as much as we all wish to live a long and healthy life, mortality risk is also a factor if you live longer than expected and have not strategized your financial life accordingly.
Liquidity Risk is the possibility that an investor may not be able to buy or sell an investment when desired. Real estate is a good example of liquidity risk, as properties cannot be liquidated on short notice with a few mouse clicks. Many excellent investments cannot be easily liquidated and should be balanced with liquid savings and/or investments.
Concentration Risk is the risk associated with holding a large portion of investments in one security type, industry, or geographic region. It’s the opposite of being diversified. People who hold large quantities of their company stock are especially at risk.
Currency or Exchange Rate Risk arises from the change in price of one currency against another. The value of various currencies are constantly fluctuating, and investors who need to convert profits from foreign assets into US dollars are especially at risk if they have invested heavily in international stocks or foreign assets.
Why Typical Risk “Solutions” Won’t Save You
Stocks vs. Bonds. Did you notice how many of the above types of risk were relevant to stocks and/or bonds? It drives us CRAZY that the most-repeated strategy for mitigating market risks is to “balance stocks and bonds” based on your age or your intended retirement date!
Yes, historically, bonds tend to do better when stocks are failing, and vice versa. But this whole line of reasoning is a bit like suggesting that you should replace some of your ice cream consumption with potato chips to “balance out the health risks.” From a risk-reduction standpoint, it doesn’t get to the heart of the matter.
Risk Assessment Profiles. These are no help, either, as they only help financial representatives steer you into certain investments while doing nothing to help you avoid risk. As we explain in “The Problem with Investor Risk Assessment Profiles,” these are designed to protect financial planners and brokers from risk—not you!
Dollar Cost Averaging. We call this “Di-worse-ification,” selling what’s doing well to purchase more of what is underperforming! Seriously, why not just invest in vehicles that work with reliable returns?
Typical solutions won’t help because “typical” strategies ARE the problem, as we detail in Financial Planning Has Failed, an ebook you can download for free here. Wall Street brokerages benefit when you put and keep your money at risk, which is why we encourage you to think outside the typical “max-out-your-401(k)”-financial-advice box.
A New Way to Think About Investments
Instead of “balancing stocks and bonds” in attempts to mitigate risk, use these six strategies to drastically reduce or even avoid investment losses altogether:
- Invest in different asset classes—especially non-correlated assets.
- Save before you invest and maintain adequate liquidity at all times.
- Protect your most valuable asset, which is your ability to earn.
- Don’t speculate or put money into volatile financial vehicles.
- Rely on investments and strategies that have proven themselves reliable and rarely produce losses (we’d be happy to recommend some appropriate for your situation), and
- Use the 7 Principles of Prosperity™ to evaluate investment opportunities.
We call our philosophy Prosperity Economics, which you can learn about in our complimentary Prosperity Accelerator Pack. Todd Strobel and I discuss how to use the 7 Principles of Prosperity™ as an opportunity filter for investments in an episode of The Prosperity Podcast, “Bringing the 7 Principles of Prosperity to Life.”
Although all seven principles will help you reduce investment risk, I want to especially highlight Principle #5, which is CONTROL. When you consider an investment, what level of control do you have over the outcome? There may always be some level of risk, however small, but you can lessen your risk by asking yourself some questions:
Have you separated your savings and investments? When you don’t have savings, you put your investments at risk should you find yourself in need of extra cash.
Are there guarantees? We love high cash value whole life insurance for the long-term liquid “savings” portion of a portfolio, because it is guaranteed to increase every year at a rate far above what banks are paying. We also love life settlements for the growth portion of a portfolio, because the underlying investment is of the highest quality (life insurance contracts) with a guaranteed future value.
Is there a predictable, reliable return? The stock market is anything bust predictable, but some bridge loan funds and other real estate strategies offer extremely predictable, reliable, contractually-agreed upon returns. Life settlement funds are immune from market swings, low interest rates, a weak economy, war, terrorism, natural disasters and politics. And life insurance dividends from established mutual companies have been paid every year for over 150 years, throughout the Great Depression, the DotCom bust, and the Financial Crisis.
Is it secured? Is your money secured against a property, deposits held by an institution, or some other asset? Stocks fail again here, and even “safe” municipal bonds can default, while well-capitalized real estate and life-insurance based financial vehicles have an advantage.
Will banks lend against this asset? If a bank won’t loan on an investment, the risk is higher. So the fact that you can’t use your 401(k) as collateral should perhaps be concerning… (See “The Leverage Test: Can You Use Your Assets as Collateral?” for more.)
What is the likelihood of loss? We’re conditioned to believe that loss is to be expected, but we disagree! You don’t have to put your money at risk.
You should only have to build wealth ONCE.
You can reduce and avoid investment risk by implementing strategies that will secure excellent returns with a minimum of losses. Our strategies have worked in any economy and have helped our clients grow their wealth steadily, earn excellent returns, and sleep at night. Find out more about our Prosperity Economics philosophy, and how Partners for Prosperity can help you.
For more on reducing investment risk, we recommend “Weatherproof Wealth: Investing for Stability in Uncertain Times”