You May Need to Take Some Risk to Meet Your Goals

Jane Young, CFP, EA

Jane Young, CFP, EA

Before you start investing, it is important to understand the relationship between risk and return and as well as what level of risk you are comfortable taking.  Generally, an investment with a higher return will involve taking on more risk.    If all investment opportunities provided the same return, everyone would select the least risky choice.  As a result, a more risky investment must provide a higher return to attract investors.  At the most basic level, an investment is where one party needs money and another party has money to lend or invest.  The investor does not want to lose his money, so he demands an increasing level of return as the risk increases.

There are many different kinds of risk.  One of the most common is market risk, or the risk of losing money in the stock market when the price of stock falls.  This can be caused by a change in the overall economic situation, impacting the entire market, or by a change within a specific company.  A commonly accepted practice for decreasing this type of risk is diversification into many companies in different industries and different geographical locations. 

When investing in fixed income or interest earning investments, such as bonds and CDs, the most common risks are default risk and interest rate risk.  Default risk is the risk that the bond issuer will become financially insolvent or bankrupt.  Bond issuers are rated based on their stability to help investors gauge how much risk they are taking.  Interest rate risk is the risk that interest rates will increase after you have purchased a bond or CD, resulting in a drop in the current market value. This is of greatest concern if you own a bond fund or don’t hold an individual bond to maturity.

Two additional risks that many investors fail to consider include opportunity loss and inflationary risk.  If you try to avoid risk by avoiding the stock market, you may hurt your chances to earn a decent return.  With current interest rates on CDs and Treasury Bonds so low, conservative investors may be unable to keep up with inflation and build their retirement plans to desired levels.   Volatility in the stock market can be very scary, but over long periods of time it has outperformed most other investments.  By avoiding the stock market you take the risk of missing out on the higher returns provided with a more balanced portfolio.  You may even lose money, if inflation exceeds the interest rate on your CDs.

Moderation is the key.  Investing your entire portfolio in the stock market is far too risky, but investing your entire portfolio in fixed income is also risky.  You risk losing the opportunity to earn a reasonable rate of return, to keep up with inflation and to meet your investment goals.  The best plan is a diversified portfolio that meets your investment timeframe and long-term goals.

Living Dangerously in the World of Fixed Income

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Jane M. Young CFP, EA

It is important for us to stay diversified and keep a prudent amount of our portfolio in fixed income investments – but where? We can avoid interest rate risk and default risk with CDs; however, we may sacrifice on return. Currently most short term CDs are paying less than one percent. We can get a slightly better return for a longer term CD but does this make sense in such a low interest rate environment? With CDs, the biggest downfall is the lost opportunity for a higher return.

If you want a higher return and you are willing to take some additional risk, consider short term bond funds. A short term bond fund that invests primarily in treasuries and government agency bonds has a very low default risk. However, there is some interest rate risk. Interest rate risk is due to the cause and effect relationship between bonds and interest rates. When interest rates rise, after the purchase of a bond or a bond fund, the value of the bond will decrease. For example, you purchase a $20,000, 10 year bond that pays 3% interest. A few years later interest rates go up to 5% and you decide to sell your bond that only pays you 3%. When you try to sell your bond you can’t get $20,000 for it because it pays 2% less than the market rate. However, several buyers may be willing to buy your bond for a discounted value to make up for the lower than market interest rate. If you hold your bond until maturity it should sell for the full purchase value of $20,000. The inverse is also true, if interest rates go down your bond will be worth more than what you paid. The degree to which this occurs is magnified by the term or duration of the bond. Short term bonds have less interest rate risk than do long term bonds.

Default risk is the risk that the company or entity issuing the bond will be unable to pay you back. In essence a bond is a loan made to a company or a government entity for a specified interest rate over an agreed upon period of time. US Government bonds and bonds backed by the US Government have an extremely low risk of default. Corporations, Municipalities, and other governmental entities have varying degrees of risk depending on their financial stability. Most bond issuers are assigned a rating to help investors assess the potential default risk of a bond.

A mutual fund has less default risk than an individual bond because you are buying an ownership share in several different bonds. However, you have less control over interest rate risk. If you own an individual bond you can hold it until maturity. If you own a mutual fund, the fund manager may be forced to sell bonds at an inopportune time due to a high rate of withdrawals. If the fund manager could hold all of the bonds to maturity there would not be an actual drop in value. However, bond funds must reflect a share price based on the current value of the bonds held in the portfolio.

If you want a higher return you may want to consider intermediate term bonds but be prepared for a corresponding increase in the level of interest rate risk. If you want to maximize return you could consider high yield or junk bonds. However, be very careful in this arena because high yield bonds are subject to both interest rate risk and default risk. In the current environment, interest rate risk and default risk are very high. Unless you are an expert in high yield bonds, this is a lot of risk to take on the portion of your portfolio that is designed to be less risky and serve as a buffer against the stock market.

Most of my clients are best served by investing in a combination of CDs, high quality short term bonds, and some high quality intermediate term bond funds. Unfortunately, there are few really good options in the current fixed income market.

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