It can be quite dangerous to be risk-averse. Seeking to reduce risk by avoiding certain investments like stocks introduces yet a different danger — that of drastically outliving your money. In short, investment risk is a double-edged sword.
Longevity risk is the chance that your retirement assets won’t last your full lifetime. The less you accumulate in retirement savings, the greater it will be.
Investors tend to focus most of their thought and effort on managing — or at least considering — four kinds of investment risk: market, business, liquidity, and international (including currency).
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Market Risk
Market risk is the chance that your investment may go down in value as part of an overall decrease in that particular market. For example, a major correction in the stock market will see nearly all stocks decline in value. Likewise, other markets — such as bonds and real estate — can see broad declines in value based on factors that impact the entire market.
Business Risk
Business risk is associated with the particular organization you invest in. The business's leaders make decisions that impact the value of the organization. While great decisions create value, poor decisions erode value.
International Risk
Putting your money in international investments introduces additional risk due to political considerations, regulations, legislation, exchange rates, and a myriad of other factors.
Liquidity Risk
Liquidity risk is the chance that you won’t be able to sell your investment quickly when you need the money. Real estate, for example, is not generally something you can sell instantaneously for its full value.
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How to Combat Investment Risk
Generally, investors manage these risks through two basic strategies — diversification and asset allocation.
Diversification
You can think of diversification in two basic fashions: In a macro sense, it involves distributing assets across investment classes. In a micro sense, it involves having multiple investments within an asset class.
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Diversification across investment classes reduces the market risk associated with investing in a single asset class.
By investing in multiple asset classes, the investor reduces the impact of one of them dropping dramatically in value.
This is also how investors manage the risk of international investing — by limiting the portion of their portfolio allocated to international investments.
You can also address liquidity risk through diversification. Generally, however, it’s better to employ a strategy of reducing positions in illiquid or volatile investments a while before needing them. For example, a retired person could maintain money for the next two years in a cash position.
Then, for the next three to five years, she can put it in very liquid, conservative investments. This nearly eliminates liquidity risk, while still allowing the investor to continue holding the bulk of her assets for long-term growth.
Asset Allocation
Asset allocation formalizes diversification across investment classes by employing an algorithm-based strategy to maintain specific percentages in various asset classes. The algorithm determines the percentages based on a variety of factors to reduce various risks. By maintaining the desired percentages, it minimizes the investor’s biases.
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Unfortunately, this risk-management scheme doesn't specifically address longevity risk. Yet people are living longer, and fewer of them will have pensions when they retire. The ability to maintain a comfortable standard of living throughout a lengthy life expectancy will require building a very significant investment portfolio.
A Final Thought
The biggest constraint that most people will have on how large a portfolio they can build is the amount of money that they can invest into it on an ongoing basis.
The second-most significant factor will be how hard that money works for them. If your investments don’t work hard for you, you may very well run out of money before you run out of life.
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Taking on little or no investment risk can be very risky in and of itself. It can cause you to run out of money in retirement. But the good news is that you can take control. Learn about investing and planning for retirement.
Find a level of investment risk at which your money works for you without keeping you up at night. Watch out for both sides of that double-edged sword!
