Overview of Investment Risks
Investing comes with a lot of risks. When you consider the different types of risks that are unique to each different type of investment, there are too many to discuss in one blog post.
That being said – from a practical perspective – all of these risks tend to fall under two broad umbrellas that long-term investors need to protect themselves from.
- The risk of losing money
- The risk of needing cash at the wrong time
The first one is pretty straightforward. If you put money into an investment and it goes to zero, it’s like you went to the casino and had a rough night. While this seems ridiculous, it does happen more than you would think. Simple diversification can limit this risk.
But a good investor – or an investor working with a good financial advisor – is more concerned with the second risk: needing cash at the wrong time. The technical term for this kind of risk is “liquidity” risk. And the higher the investment volatility, the higher the liquidity risk.
We often think of volatility in negative terms. When the stock market crashes, the media often will say it was a “volatile” period for stocks.
But it’s important to remember that volatility cuts in both directions. An investment that can go down a lot, can also go up a lot. When our investment goes down by 20%, we hate volatility. But when it goes up by 20%, we love volatility.
Consider the broad stock market. As you can see in the following chart from Investopedia, there have been several times where the S&P 500 has gone down a lot. And if you sold when it was down, you lost your money.
But more often than not, it goes up a lot. A good investor will have a plan to avoid selling during a downturn, to pay for expenses.
By all accounts, the stock market is risky (volatile). But, as long as you don’t need your money too soon, you should be able to ride out the storms and make a lot of money in the long run – thanks to the power of compounding returns.
On the other hand – if you’re forced to sell at a low point – your financial future could be destroyed.
Mitigating liquidity risk with investment time horizons
As I mentioned, the higher the volatility of an investment, the higher the liquidity risk of that investment.
If you need to access your money in less than 5 years, it’s probably not a good idea to have a lot of it in stocks. What if the market crashes? You don’t have time to wait for a recovery.
But if you don’t need it for another 30 years, it might be ok to have it all in stocks.
This is why I divide my clients’ investment strategy into time horizon buckets. The idea is to have different buckets of money that you can draw from at different points in time.
I use a short-term bucket for any money that can be accessed within the next 5 years. I use a medium-term bucket for any money that can be accessed within 5 – 20 years. And I use a long-term bucket for any money that can be accessed in 20 years or more.
The short-term bucket consists of checking accounts, high-yield savings accounts, and select low duration bond funds.
The medium-term bucket consists of a properly diversified stock and bond portfolio.
The long-term bucket consists of a properly diversified stock portfolio. But I also invest this bucket in long-term themes. I will get into the details on these investments in later posts, but for now I’ll simply list them for you: potential medical breakthroughs, the clean energy industry, the cannabis industry, the cybersecurity industry, the fintech industry, and broad-based disruptive innovation.
Because this money is earmarked so far out in the future, it’s ok to take smart risks in exchange for potentially more wealth over time.
Example 1: Accumulation Phase
For someone who is in the accumulation phase of investing – in other words, not yet taking income off their investments – the three buckets would be as follows.
The short-term bucket is an emergency fund with enough money to protect you from temporary loss of income. A rule of thumb is to have 3-6 months’ worth of expenses set aside in this bucket. But this can vary significantly from person to person, as there’s a lot of subjectivity behind it. This money can also be used for unexpected expenses like home or car repairs.
The medium-term bucket is a “financial freedom” fund. With the objective of gaining financial freedom (or at least more flexibility on how you spend your time) before you reach the traditional retirement age of 60.
Any other goals that fall within the 5-20 year time horizon will also be funded by this bucket. But labeling this as a financial freedom fund helps you plan your life. A good financial planner will use software that allows you to look at every goal through the lens of “how long will it delay my financial freedom and is it worth that sacrifice?”
The long-term bucket is your traditional retirement assets. This would include your 401(k), IRA, Roth IRA, etc. Thanks to your medium-term bucket, you’ll want to delay withdrawals from this bucket as long as possible. Because of this long time horizon, you can add risk – managed prudently, of course – to increase your wealth building potential and ensure you never run out of money.
Example 2: Distribution Phase
For someone who is in the distribution phase – in other words, taking income off their investments – the three buckets would look slightly different.
The short-term bucket is still an emergency fund. But rather than protecting you from temporary loss of income, it’s intended to protect you from steep (but temporary) stock market declines.
The income you’ll generate from your investments will be created by selling a small piece of your portfolio to raise cash. And – as discussed above – you don’t want to sell when your portfolio is down significantly.
Depending on your risk tolerance, anywhere from 18 months to 4+ years worth of withdrawals should be set aside in the safety of this bucket. This will allow you to ride out a bear market without destroying your financial future.
The medium-term bucket consists of the invested portion of your assets. This is meant to continuously grow your wealth over time. Depending on your risk tolerance, it should be a diversified portfolio of stocks and/or bonds.
As this bucket grows, so does the level of income you can generate. Which allows you to increase your lifestyle or use the extra money to create more impact for others.
It also decreases the likelihood that you’ll run out of money at some point. Because over time – as long as you aren’t forced to sell low – it’s likely that your investment returns will exceed the amount of income you’re taking.
The long-term bucket is your legacy fund, if you want one. Otherwise you can just stop at bucket #2. With an inheritance fund, you no longer need to use your time horizon. You can use their time horizon.
For example, if an 80 year old person expects to live another 10 years, they have a time horizon of 10 years. But if the money is an inheritance for a 35-year-old grandchild, the time horizon suddenly becomes 20+ years again.
As long as proper communication and estate planning has been conducted with your heir, this can be invested much more aggressively to pursue greater growth potential.