What risks are lurking in your investment portfolio?

by Matt Quinn, CFA®

For my birthday in April, I went on a wonderful scuba diving trip with my wife to Cozumel, Mexico.  While some of you may think a trip to Mexico sounds dangerous, the island of Cozumel in the Yucatan peninsula is really a sleepy island next to one of the largest coral reefs in the world.  Others of you may consider scuba diving a risky activity.  To be sure, diving does come with certain risks, but for trained divers going with a certified dive master and an experienced boat crew, risks can be minimized.  And the rewards on this trip were plentiful, as I was able to see beautiful colors of coral and sea sponges and get up close and personal with spiny lobsters, sea turtles, nurse sharks, barracudas, eagle and sting rays, eels, and big schools of colorful fish. 

Webster’s defines the word risk as “the possibility of incurring loss or injury”.  Most life insurance companies consider scuba diving to be a high-risk activity.  Yet, on this diving trip, no one on my dive boat experienced any loss or injury.  We did have one diver that panicked during a dive due to the strong currents, but the dive master was able to calm the diver and keep things under control.

In the physical world, we face risks daily and often look for ways to minimize the risk associated with that activity.  For instance, most of us fasten our seatbelts when we get into a car.  While one doesn’t fasten their seatbelt because they plan to get into an accident, they do so just in case they get into an accident.  Certainly, a seatbelt doesn’t prevent someone from getting into an accident, but wearing one every day does reduce the potential of serious injury or even death resulting from an accident.  Drivers also insure their cars to limit the financial impact of an accident.  Again, having insurance doesn’t prevent accidents, but it does help to minimize the financial risks associated with driving.

In the investment world, risk is the chance that an investment will lose value.  But how does one measure risk, particularly in a period right now where risk seems to be everywhere?  Some investors look at risk as price volatility.  For instance, we look at statistical measures such as standard deviation to understand the price volatility associated with a particular investment.  This is a lot like how an insurance company may look at pricing your auto insurance.  Using statistics such as your age and driving history does provide some insight into how risky individuals of your age and driving history may be to insure.  But statistical measures by their very nature are backwards looking and based on events that happened in the past.

So, what are the primary risks we think investors should be aware of in their investment portfolios?  We generally think of investment risk as fitting into one of four categories:

·         Interest rate risk impacts investments that are sensitive to changes in interest rates.  This includes most types of bonds or fixed income investments.  As interest rates rise, the price of a bond will fall.  After all, if a bond investor can make a new investment that provides a higher yield, then they will look to replace the investment they hold and thus create downward pressure on prices of existing bonds relative to newly issued ones.  This risk was prevalent in financial markets in 2022, as the Federal Reserve raised its federal funds target rate by 4.25% through seven rate hikes.  Bond prices declined in 2022 and the US Aggregate bond index lost 13%. 

 ·         Credit risk is the risk that a bond issuer won’t be willing or able to repay their debt.  The ongoing debt ceiling debate is one example of this risk.  While the US government is more than capable of repaying its debts, a law enacted way back in 1917 has created political standoffs that have and can lead to rating downgrades and increased uncertainty across financial markets.  The more common type of credit risk comes from borrowers that may not be able to meet their debt obligations such as individuals, corporations, and municipalities.  When one of these entities fails to pay off its debts or make interest payments, then the entity will go through some sort of bankruptcy or restructuring proceeding where the bondholders may still get all or a portion of their money back.

 ·         Systematic or market risk is the risk that you can’t minimize through diversified equity investments, but that you can mitigate by holding some cash or fixed income investments in a portfolio.  Examples of systematic risk would include the COVID-19 market event we experienced in February/March 2020 when all stocks fell in advance of a potential global economic shutdown related to the spread of COVID-19.  Inflation is also a systematic risk that the market has been dealing with for a while now.

 ·         Unsystematic or systemic risk is the risk associated with investing in just one company or industry.  Enron is the best example of single company risk, where actions by a few individuals led to the collapse of an entire company.  Other than fraud or bankruptcy, systemic risks often impact groups of companies based on their customer base or business activities.  A good example is what happened recently in the banking industry as several banks failed due to the combination of their customer base and business activities.  This type of risk can also be mitigated through diversification although sometimes systemic risks can spread to the entire economy as we saw with the financial crisis of 2008/09.

We have found that the best way to reduce investment risk is with both diversification and time.  From a diversification standpoint, we utilize investments that have varying degrees of exposure to these four investment risks.  While you may think there are investments with no risk, the truth is that every investment is at risk in one way or another and sometimes exposed to multiple risks.

Have questions about what risks are prevalent in your portfolio?  As always, we would be happy to answer any questions you may have whether you are a client or prospective client.  We have the tools and resources at our fingertips to give you the information you want.

Disclosures

• Legacy Consulting Group is registered as an investment adviser with the SEC and only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.

• Information presented is believed to be current. It should not be viewed as personalized investment advice. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed.

• All investments and strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that an investor’s portfolio will match or exceed any particular benchmark.