July 28, 2014 in Investing

5 investment risks and how to manage them

Risk means different things to different people.

They may characterize themselves as aggressive or conservative when it comes to investment risks, without understanding how that pertains to their holdings. For instance, investors think putting all their money in bonds might make them conservative, but if interest rates rise, their bonds will surely lose value.

“People talk about their risk tolerance, but when you change the question to what’s their loss tolerance, they answer differently,” says Jeremy Kisner, senior wealth adviser at Surevest Wealth Management in Phoenix and Las Vegas. “A lot of people don’t understand risk.”

Your age plays a role in the investment risks that you can tolerate, and even what you should worry about. For younger investors, who have many years to grow their nest egg, volatility is their concern. Older investors, who are hopefully out of the money-generating stage and in the preservation stage of investing, have to contend with inflation and interest-rate risk.

From longevity risk to interest-rate risk, here is a look at five investment risks and how people of every age face them.

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Anyone who has invested in the stock market is aware of the gyrations that can wreak havoc on a portfolio, as well as the psyche. That’s why money managers say you need to figure out how much volatility — or stock and bond price gyrations — you can handle to prevent panic from sinking in.

One way to gauge that is to determine how long your money can grow before you need to access it, says John Sweeney, executive vice president of retirement and investing strategies at Fidelity Investments. Investors who are saving for retirement but have 30 more years to go in the workforce can handle more volatility then someone who is nearing their golden years.

“If you don’t need your money when you are 40, but you do at 65, you shouldn’t worry about volatility (now),” Sweeney says.

Investors only have to look at the stock market bust of 2008 for further evidence. Many people who didn’t sell off their stocks ended up recouping those losses four years later. On the flip side, investors who were about to retire had to postpone or exit the workforce with a smaller nest egg.

Whether you are 30 or 60 years old, there is a chance that once you retire, you will outlive your money if you are not careful. Scores of people are living in retirement for 30 or more years, which means they have to make their money last. That’s where the longevity risk comes in.

Younger investors have an advantage because they have more time to make sure they save enough for retirement, but for people nearing retirement, they’ll have to curb their lifestyle or make their investments generate more income if their spending exceeds their cash flow.

One way to increase the amount of cash flow from investments is to invest for yield or return, says Nicholas Yrizarry, CEO of Nicholas Yrizarry Wealth Management Group in Laguna Beach, California. That could mean investing in dividend-paying companies or fixed-income products that have higher rates of return than what investors are currently getting, says Yrizarry. It also means looking at your budget, lifestyle and size of your nest egg to come up with ways to make the money last over the long haul.

“If you live long, there’s a greater likelihood of running out of money,” Yrizarry says. “The primary risk is longevity risk.”

People in their late 50s or 60s should have moved out of the stage where they are focused on growing their money and into one where they are protecting what they’ve made. That doesn’t mean they should pull all their money out of the stock market and put it under their mattress. But they should start looking at ways to minimize any capital preservation risk, says Anthony Saccaro, president of Providence Financial & Insurance Services Inc. in Woodland Hills, California.

“If you are older, it becomes more about protecting your principal as opposed to trying to grow it,” Saccaro says.

Diversity is the key with any investment portfolio. But Saccaro says older investors should start investing in things that will produce a return but at the same time protect the principal investment. That could mean bonds, certificates of deposit, annuities or anything that pays a set interest rate, he says.

“When you are younger, the risk is losing your principal in the stock market,” he says. “If you are older, you shouldn’t have stock market worries.”

Everyone knows there’s a risk of inflation but what many people, especially those nearing retirement, don’t understand is the impact that inflation can have on their investments.

“Inflation risk can be devastating,” says John Gajkowski, principal of Money Managers Financial Group in Oak Brook, Illinois.

“Even though they are getting the same pension check, what they can buy with that check goes down every year, depending on inflation,” he says.

According to Gajkowski, investors have to be aware of that risk when investing, especially when they are trying to be conservative.

For instance, a 4 percent return on an investment may seem nice, but if an investor is in the 33 percent tax bracket and is clearing only 2.8 percent from investments and inflation is 3 percent, he or she is losing purchasing power from those investments.

“In an inflationary environment, things like bonds or longer-range CDs are bad, if you locked into a particular rate,” he says. “Two percent might look attractive on a 10-year bond, but in two years that rate may be 4 percent or 5 percent for the same type of bond.”

For some years, investors have enjoyed record low interest rates, as mortgages have been cheap and people have gobbled up government bonds. But interest rates aren’t going to remain low forever, which means bond investors are poised to face more risk.

“Every 1 percent increase in interest rates can devalue a bond by 10 percent to 15 percent,” Yrizarry says. “A risk-adverse person has to be aware that interest rate fluctuations control the value of bonds.”

To counter some of that risk, money managers say bond investors should stay away from long duration bonds and skew toward short- to medium-duration ones. Investors in the stock market don’t have to get into defensive mode like bond investors do because of rising interest rates. That’s because rising interest rates typically signal an improving economy, a better job market and growth from corporate America, which bodes well for stocks.

“A lot of people want to take risk or don’t want to take risk, based on how it makes them feel,” says Kisner of Surevest. “But how much risk you should take is based on what gives you the highest probability of achieving your goals, not based on emotion.”