Posted: 10-18-24 | Zach Terpstra
What is Risk?
Risk takes on many shapes and is omnipresent. In its rawest form, risk can be explained as the probability of an event occurring which leads to an undesirable outcome. At any given time, all of us are exposed to varying degrees of risks with differing severities associated with each outcome. Because risk can take on many appearances, every situation we encounter has the chance of an undesirable outcome associated with it. The likelihood and impacts of certain risks may be small, but never absolutely zero.
Understanding Risk Tolerance
In situations where risks are minuscule, such as the probability that we are struck by lightning on a bluebird sky day, we often cope by correctly rationalizing that most of these risks are beyond our control. In our investments, rather than choosing to negate or avoid risk across every situation, most of us implicitly develop a tolerance to certain thresholds of hazardous outcomes. If your true needs in life are met, this can dictate the floor to which we can begin to intentionally seek risk in expectations for being rewarded in the long run with higher returns. Even if one has a financial capacity for risk, that does not default to us seeking to add more risk into our investments. Alongside a solid balance sheet, investors must also have their behavioral tolerance to risk correctly defined and identified. Each of these is personal to the individual, and that is important. Working within our personal framework, whether written down or mental, allows us to identify risks such as longevity risk, purchasing power risk, and liquidity risk relative to our needs.
Types of Investment Risks
Longevity Risk
Longevity risk refers to the principle that we may or may not outlive all our assets. Because none of us know how long we are going to live, we need to make assumptions when considering our investment timeframe. If I believe I will live to eighty-five and draw on my portfolio to die with zero assets in my name, unexpectedly living to ninety could become a problem. Many market participants incorrectly assume that offsetting an unfavorable forecast by overweighting high-returning asset classes, such as equities, will compensate for longevity risk. This only compounds the problem. By going to the market to solve our problems we introduce a litany of investment-related risks into the equation. Compensating for one risk by adding another is not always conducive to our goals, and managing our outflows tends to be a simpler solution to mitigating this undesirable outcome.
Purchasing Power Risk
Purchasing power risk, which can directly impact our withdrawals from our portfolio, is closely related to longevity risk. Inflation slowly eats away at the worth of your dollar over time, thereby decreasing your purchasing power unless your assets are growing in value over the same period. Unless you do not have assets, you cannot avoid purchasing power risk in your life. Ultimately, faced with the inability to eliminate purchasing power risk, the goal ought to be to manage it. Investing in assets that are expected to beat inflationary pressures is the recommended approach. Assets like true cash and some hard commodities tend to lose value relative to inflation over time. Many are surprised about the commodities quip, and ultimately commodities that have a function or utility become cheaper over the long run as production and extraction of commodities continue to become more efficient. Without having assets that seek real yield or total return, inflation can continue to reduce your purchasing power.
Liquidity Risk
Liquidity risk can be applied and defined in a litany of different ways, but ultimately boils down to the risk of needing your cash but being unable to access it. Contractual obligations, illiquid markets, or mismanaged cash flow planning are all sources of liquidity risk. If you have an expense or need which cannot be met due to lack cash on hand, it will force you to seek cash from your portfolio. Reducing the amount one has invested to meet your expenses thereby impacts the long-run growth of the portfolio, again compounding the problem only further. Having a diversified source of assets to draw from within a portfolio creates a liquidity ladder; a predetermined order of assets to liquidate depending on the obligation.
Next Steps
The challenge with all the defined risks above is that each of them are present irrespective of how we invest our assets. Our perception of these risks can be heavily influenced by the media, our peers, knowledge of investments, or lack thereof. Risk attribution, a process of determining the sources of potential peril, can be conducted periodically as a form of stress-testing portfolios to ensure we are comfortable with the level of risk we are engaging with at any given time.
For our clients, Innovia utilizes a wealth allocation framework to identify assets inside and outside of your portfolio to be categorized into various classifications of risk. By pairing this methodology with your goals, we strive to create an asset allocation unique to you which targets real returns alongside identifying a tiered liquidity ladder to draw from in a worst-case scenario.
Contact us today for a 15-minute introductory call to discover how Innovia Wealth can work with you to create an asset allocation unique to your risk tolerance.