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Balancing Risk

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Often times when financial professionals talk about risk, they are describing the volatility that is associated with the financial markets.  A closer look at risk reveals more than meets the eye.

I often tell clients, there are two specific risks that need to be planned for:  short-term risk and long-term risk.  First, it makes sense to identify and define these risks.  Short-term risk involves volatility.  Any time you invest your money there is a chance that there will be a loss of value in your investment.  If your investment goes down in value, and you need to access to those funds in the short-term, you will experience a loss.  The reason we refer to this phenomenon as short-term risk, is that volatility, or short-term risk, typically subsides with most investments, as time progresses.  This is shown in the chart below which displays statistics from the S&P 500 from 1926 through 2004:

Length

Time Period

Average Annual Return

Worst 1 year period

1931

-43.35%

Worst 10 year period

1930-1940

-1.0%

Worst 30 year period

1929-1959

8.6%

As shown by the chart, there is a substantial drop in volatility as the holding period increases.  Long-term risk, is the threat most people underestimate.  This risk is often called inflation, and it involves running out of, or outliving your money.  The rising costs of goods and services mean that a dollar today is not worth as much as a dollar ten years ago.  For example, look at the chart below:

Item

1969

1989

1999

Bread

$0.29

$1.29

$2.46

Dozen Eggs

$0.47

$1.19

$2.25

Movie Ticket

$1.00

$5.00

$12.00

New Ford Car

$2,200

$14,000

$33,000

3-Bedroom Home

$19,000

$105,000

$248,000

Prices and projections in this chart are estimated based on historical data. This data cannot be relied upon for complete accuracy or to indicate future trends.

As you can see, the cost of goods and services, increase due to inflation.  For an individual to maintain their standard of living, they must increase their income at the same rate.

As a financial planner, one of our jobs is to identify risks that are inherent to our clients situations and either avoid, transfer or minimize those risks.  First, let’s look at volatility, or short-term risk.  One of the easiest ways to avoid this potential pitfall is to allocate all of your resources to stable assets, like checking and savings accounts.  Unfortunately, by avoiding volatility you will inevitably be exposed to inflation risk.  Conversely, this inflation risk, can typically be minimized by investing one’s assets in growth investments like stocks.  Since these investments have historically outpaced the inflation rate, individuals can experience a growth in their assets, at the same time the growth in expenses is occurring.  By placing all of your assets in growth investments, you will limit your exposure to inflation, but will experience significant volatility.

So what should you do?  There is an inverse relationship between long-term and short-term risk, meaning that as you try to avoid one type of risk, you experience increases in the other.  The key in managing these risks is balance. By allocating a percentage of your assets to stable assets, and a percentage to growth assets, you are able to minimize the risks inherent in your situation.  How much you allocate to each asset class has to do with several variables which we will cover in greater depth in a future article.

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

07/20/2011 Tagged ,


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