The Different Types of Risk
Thursday, March 22, 2018

Last week’s commentary about how tolerance for risk changes with age prompted a few readers to respond. Most of the emails I received focused on defining what risk is. In the world of finance, risk has more than one definition.

Risk questionnaires often try to assess a person’s willingness to incur a drop in a particular investment or net wealth. For example, Vanguard’s risk assessment questionnaire asks respondents to choose one out of three hypothetical $10,000 investments. The least volatile option has a very minor one-year downside (a loss of $164), while the most volatile investment could experience significant losses ($3,639) over a one-year period. Schwab asks respondents what they would do if the stock market lost 25% of its value within three months. Other firms ask similar questions.

Risk in these cases is being assessed in terms of a person’s ability to withstand losses. The questionaires are designed to assess an individual’s psychological ability to handle shorter-term drops in their wealth. It’s logical to do so since many investors panic and sell whenever the market conditions turn turbulent. We humans are hardwired to disdain losses. However, a drop in price—real or hypothetical—isn’t the only way to assess risk.

Academic theories of asset allocation consider systematic and unsystematic risk. Systematic risk is the chance of losing money due to broad market moves. Another description for it is macro risk. The new tariffs on Chinese imorts and the stock market's initial negative reaction to them are examples of systematic risk. Unsystematic risk is specific to a given investment. It is the chance of loss related to the performance and characteristics of an individual security. Facebook Inc. (FB) shareholders encountered unsystematic risk when the news about Cambridge Analytica broke.

You can reduce unsystematic risk by holding a variety of stocks from different sectors, of different sizes and with different characteristics (growth, value, etc.). Broad market funds, both mutual and exchange-traded, are an easy way to reduce unsystematic risk. You can reduce systematic risk exposure by holding a mix of different assets such as stocks, bonds, gold, etc.

AAII founder James Cloonan uses another term to describe the volatility used to measure systematic risk: phantom risk. Phantom risk is the volatility of the market. Jim used the term “phantom” because he views the real risk as not having enough money in the future when you need to spend it. While phantom risk can be unnerving, not having enough money in the future could leave you exposed to longevity risk, which the risk of outliving your savings. Shying away from incurring phantom risk can also reduce your future purchasing power (the ability to buy goods and services with the dollars you have), which is directly tied to inflation risk.

Even though we think investors should ignore short-term volatility, sequence of returns risk must be considered. This is the order in which returns occur. If you need a certain sum of money, say, in two years, and a steep correction or a bear market strikes, you may not have the necessary assets to meet your short-term goals. This is why investors can be well served incorporating some type of barbell or bucket approach, with savings split by timeline. Incur systematic and phantom risk for money not needed within the next five or so years (extend the range by a few years longer if that makes you more comfortable) while conservatively investing the money you will or may need sooner.

Finally, understand that without risk there is no return. Short-term systematic risk is the price you pay to realize higher annualized returns over the long term.

More on

  • Why a New Allocation Approach Is Needed – AAII founder James Cloonan explained why he believes the traditional way of allocating portfolios fails to consider how risk actually occurs in the real world.
  • How Big Is Longevity Risk? – The uncertainty of how long a person will live poses negligible risk at younger ages, but substantial risk at older ages.

Highlights from this month's AAII Journal

The Week Ahead

The U.S. stock exchanges will be closed next Friday while the bond markets will close early in observance of Good Friday.

Eight S&P 500 companies are scheduled to report: Red Hat Inc. (RHT) and Paychex Inc. (PAYX) on Monday; IHS Markit Ltd. (INFO) and McCormick & Company Inc. (MKC) on Tuesday; Walgreens Boots Alliance Inc. (WBA) and PVH Corp. (PVH) on Wednesday; and Lennar Corp. (LEN) and Constellation Brands Inc. (STZ) on Thursday.

The week’s first economic report will be the January S&P Case-Shiller home price index and the Conference Board’s March consumer confidence survey, released on Tuesday. The second revision to fourth-quarter final GDP, February international trade and February pending home sales will be released on Wednesday. Thursday will feature February personal income and spending, the March Chicago Purchasing Managers Index (PMI) and the University of Michigan’s final March consumer sentiment survey.

Four Federal Reserve officials will make public appearances: New York president William Dudley and Cleveland president Loretta Mester on Monday; Atlanta president Raphael Bostic on Tuesday and Wednesday; and Philadelphia president Patrick Harker on Thursday.

The Treasury Department will auction $30 billion of two-year notes on Monday, $35 billion of five-year notes on Tuesday and $15 billion of two-year floating rate notes (FRNs) and $29 billion of seven-year notes on Wednesday.

What’s Trending on AAII
  1. Retirement Planning Strategies Following the 2017 Tax Act
  2. Tax Guide Update: The Tax Cuts and Jobs Act and 2018 Taxes
  3. Useful End-of-Life Documents
AAII Sentiment Survey

Pessimism rebounded to a six-week high in the latest AAII Sentiment Survey, though it continues to remain below average. Both optimism and neutral sentiment declined.

Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 3.6 percentage points to 33.2%. The drop keeps optimism below its historical average of 38.5% for the fifth time in seven weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 3.5 percentage points to 38.3%. Even with the decline, neutral sentiment remains above its historical average of 31.0% for a fifth consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 7.2 percentage points to 28.5%. This is a six-week high. Even still, pessimism remains below its historical average of 30.5% for the 14th time in 15 weeks.

At current levels, all three indicators are within their typical historical ranges. Most of the responses to this week’s survey were recorded before yesterday’s interest rate hike announcement.

Many individual investors are anticipating continued volatility and/or think the current political backdrop could have a further impact on the stock market. Trade policy is influencing some individual investors’ sentiment, but not all. Similarly, higher interest rates are having an influence on some, but not all. Also influencing sentiment are valuations, tax cuts, earnings and economic growth.

This week’s special question asked AAII members what influence fourth-quarter earnings had on their outlook for stock prices. The majority of respondents fell into one of two groups. Slightly more than two out of five respondents (43%) said fourth-quarter earnings had limited or no influence. Many of these respondents pointed to other factors such as politics, the new tax law and trade policy. Others said they simply do not focus on quarterly earnings. Approximately 39% of respondents view fourth-quarter earnings as being positive for the stocks. Several of these respondents believe profits will help to support stock prices, while others view earnings as helping to offset other negative factors. Just 16% expressed a negative view of the market, primarily citing either the political backdrop or prevailing valuations.

Here is a sampling of the responses:

  • “Not much. The market is too focused on Washington and its circus.”
  • “They were certainly encouraging. The real risk, in my view, is not the economy, but global and political.”
  • “Reaffirmed my outlook for continued positive upward momentum.”
  • “Earnings were good, but not good enough to support current stock prices.”
  • “Some. I’m more concerned about interest rates and the overdue correction.”

This week’s Sentiment Survey results:

Bullish: 33.2%, down 3.6 points
Neutral: 38.3%, down 3.5 points
Bearish: 28.5%, up 7.2 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!