What risks are hidden in each asset class?
Academics and finance professionals sometimes refer to the “risk-free rate of return” as a benchmark; in this context, the risk-free rate is the return on cash, where you are assured of stability of principal even if you get a small (very small these days) return.
But despite the ubiquity of the term “risk-free rate”, no investment is 100% free from all possible risk. Even if the assets placed in certificates of deposit and online savings banks do not fluctuate in value, the investor who places too many assets there can face other types of risks, in particular the risk of inflation and the risk of shortfall.
Meanwhile, stocks have a much higher level of risk in the conventional sense, in that you could lose all your money and never get it back. At the same time, an investor who buys and holds a portfolio primarily of stocks is generally less at risk of shortfall than an investor who has parked the same amount of cash over several decades.
Since every type of investment carries at least some type of risk, investors would do well to ensure that they understand the key risk factors associated with each asset class, build well-diversified portfolios across classes assets (and, in turn, risk factors), and do not take on more risk than they can afford, given their time horizon.
Here is an overview of some of the main risks associated with each asset class. Note that some of these risks are relevant to all asset classes: for example, valuation or price risk is primarily associated with holding stocks, but it can also affect bond investors.
Cash and cash equivalent investments
Inflation risk: One of the big risks for investors in fixed-rate securities – and especially very low-yielding securities like cash – is that their investments may not earn enough to keep up with inflation over time. That’s certainly a big risk today: cash yields are mostly below 1% right now, but the most recent reading of the consumer price index is up more than 7% from compared to the previous year. This means that investors who hold too much cash today are not even preserving their purchasing power. This isn’t so bad for the expenses at hand, but the longer the holding period, the more the risk of inflation should be a concern.
Risk of loss of profit: Investors may not achieve their financial goals for many reasons, but the main one is lack of savings. But if you’re saving for a long-term goal, holding too many investments with little or no short-term volatility — but commensurately low returns — can help exacerbate the risk of shortfall.
Interest rate risk: Interest rate risk is the possibility that interest rates will rise, thereby driving down the prices of already existing bonds with lower yields attached to them. The longer the duration of a bond portfolio, the more vulnerable it will tend to be to rising interest rates. Indeed, investors in long-term bonds will not only be locked into holding a low-yielding asset when rates rise, but they will be forced to hold onto it for longer, increasing their opportunity cost. Investors can mitigate interest rate risk somewhat by holding individual bonds to maturity, but it can be difficult for small investors to build well-diversified portfolios of individual bonds. Investors can use duration to gauge the degree of interest rate sensitivity built into their bond funds.
Credit risk: Credit risk is the possibility that a bond issuer may not be able to pay its debts. To help offset this risk, bond issuers with lower credit qualities generally have to pay their bondholders higher yields than high-quality companies issuing bonds of the same duration. The risk of default is not the only reason why holders of lower quality credit securities may struggle: in times of economic difficulties, such as the financial crisis of 2008 and March 2020, investors often sell bonds of low quality preemptively, driving down their prices.
Inflation: As with cash, investors earning a fixed return on their bond investments will see their actual yields decline as prices rise. Inflation-protected Treasury securities and I-bonds include an inflation adjustment on top of the yields offered by the bonds, effectively eliminating the risk of unexpected inflationary shocks for bondholders.
Reinvestment risk: Reinvestment risk generally means that the holder of a security will be forced to reinvest in a less attractive security or environment than it originally had. For bondholders, it is the risk that bond issuers refinance their bonds in an effort to reduce their interest payments, leaving the bondholder to reinvest the money in a low-yielding environment. .
Risk of change: Foreign bondholders face all of the risks described above, but they may also face a few additional risk factors. One of the most notable is currency risk: the possibility that the currency in which the bond is denominated will fall against the investor’s home currency, reducing or even negating any appreciation of the bond itself during the investor’s holding period. Some foreign bond funds hedge their currency exposure to effectively eliminate the effects of currency fluctuations on returns, thereby reducing volatility and making returns more bond-like.
Geopolitical risk: Foreign bondholders could also see the price of their bonds fall due to geopolitical concerns. For example, political unrest in the country in which an issuer is domiciled can cause real problems. Even if investors in these bonds do not believe that a default is imminent, other investors may demand a higher yield from the bonds to make the risks worth it, thus driving down bond prices.
Valuation risk: Valuation risk may apply to buyers of all assets. Simply put, by paying too much for an asset, investors may earn an insufficient return (or even a loss) over their holding period. Valuation risk can be a key risk for equity investors, which is one reason Morningstar equity analysts focus heavily on determining companies’ fair values.
Fundamental risk: This is the risk that the business fundamentals of companies – their earnings and profitability, for example – fail to meet investors’ expectations, thus causing the value of their shares to fall.
Economic risk: This is the risk that the economy as a whole could pull back, affecting business fundamentals across all sectors and companies. Companies that operate in economically sensitive sectors (manufacturing, basic materials and energy) tend to be particularly sensitive to the strength and direction of the economy. On the other hand, companies that sell products that people need, such as toothpaste and pharmaceutical manufacturers, tend to be less sensitive to the strength of the overall economy.
Liquidity risk: This risk can apply to many types of assets, not just stocks. Typically, this means that there is no ready market for a given asset, so an investor may not be able to offload the security when they want or at the price they would like. he brings back. Liquidity tends to be a particularly big issue for stocks of very small companies, but it can also apply to bonds.
Risk of change: As with foreign bonds, this is the risk that currency losses will reduce the gains or magnify the losses associated with the underlying investments. Although foreign currency fluctuations can have a significant impact on the returns that U.S. investors get from investing in foreign bonds, currency fluctuations generally play a smaller, but still important role in foreign stock returns.
Geopolitical risk: Geopolitical risk can weigh on foreign equities, as it does on bonds, as investors will tend to shed securities from countries experiencing military action or economic or political unrest. For example, Russian stocks have fallen so far in 2022, due to its impending military actions in Ukraine as well as the threat of further economic sanctions.
Economic risk: Investments in commodity tracking are often touted as good inflation hedges, as commodity prices often rise just when consumers have to pay higher prices for goods. However, the flip side is also true: when economic growth and consumption are slow, commodity prices often lag.
contango: Since most commodity tracking investments use derivatives rather than directly investing in commodities and taking ownership of them, there is a risk that the price of futures contracts will not directly match at the spot prices of real commodities. In the case of “contango”, the price of futures contracts for a given commodity is higher than the spot price.