In general, the primary purpose of your investment portfolio is to meet your stated goals. Thus, risk management is defined as limiting your portfolio’s exposure to the risks that could prevent you from reaching your stated investment objectives over your given time frame. There are three basic portfolio risks that can prevent you from reaching your investment objectives:
Capital Risk—The possibility of sustained losses over your investment time frame. Capital Risk is what most of us think about when we consider our portfolio’s risk level. However, we must talk about exposure to Capital Risk in terms of a time frame that is relevant to you and your investment objectives. For most of us, quarter-to-quarter volatility is not a meaningful measure of Capital Risk, because our goals are longer-term (e.g., to fund retirement). Often, by focusing on volatility, Capital Risk will be overestimated while other risks will be left unprotected.
Inflation Risk—The chance of losing purchasing power as a result of negative inflation-adjusted returns. Those who remember the 1970s have some idea of what Inflation Risk is. In fact, based on inflation-adjusted returns for stocks and bonds, the 1970s was a worse decade for investing than the 1930s. Short-term fluctuations in the cost of living have an impact on the returns of every asset, but some assets adjust their earnings power over time to an inflationary environment. Since Inflation Risk is the risk of a sustained loss of purchasing power, quarter-to-quarter changes in inflation are not necessarily a relevant measure of this risk to your portfolio.
Reinvestment Rate Risk—The risk of investing at low rates of return, thereby failing to achieve total returns over your investment time frame sufficient to meet your goals. The single most important risk for long-term investors over the 1980s and most of the 1990s was Reinvestment Rate Risk. However, Reinvestment Rate Risk is the risk which is least often understood by even professional investors. Reinvestment Rate Risk is important to investors with a long-term time horizon for their investment assets, because a generally low or falling return environment may not offer returns sufficient to meet long-term goals. For example, an investor earning annual returns as high as 14% - 15% on a portfolio consisting solely of 3-month Treasury Bills in the early 1980s saw rates fall to near zero since the end of 2009, as fear and market volatility have driven investors to safe haven investments. In contrast, longer-term assets generally provide better protection against Reinvestment Rate Risk, as long as they are not trading at speculative valuations.
Different asset classes generally provide exposure to and/or protection from the different risks. As such, there is an inherent tradeoff between types of risk. The chart below shows which common asset classes (i.e., short-term Treasury Bills, long-term Treasury Bonds, and stocks) tend to provide the greatest protection from and exposure to each type of portfolio risk. However, the most relevant risks facing long-term investors can change as the market environment changes over time. Prudent risk management should focus on prioritizing the importance of protecting against each risk and understanding which risks are the highest under current market and economic conditions.
How much exposure to each of these risks is right for you? This question is complicated due to the inherent tradeoff between these risks. For example, if you limit exposure to Capital Risk via investing in U.S. Treasury Bills, you will have heavily exposed yourself to Reinvestment Rate Risk, and possibly to Inflation Risk as well. However, if you prioritize the importance of protecting against each risk and base a statement of investment objectives on those priorities, your financial advisor and investment manager will be able to better help you try to reach those objectives.