AAII Asset Allocation Models Mini Course

Step 3: What Risks Do I Need to Take Into Account?

Earlier we identified the primary investment risks: business and industry risk; market risk; inflation risk; and liquidity risk. Using the historical data, you can start to get an idea concerning the risks and potential returns of the three major categories.

Business and industry risk:
At this level, you don't need to focus on business and industry risk because it can be eliminated by diversifying within each category. For instance, within the stock segment, business and industry risk can be eliminated by diversifying among different stocks within different industry groups. However, don't forget this risk at the later stages—it will be a major concern.

Market risk:
Both stocks and bonds face substantial market risk—a rise or fall in the value of the investment due to market conditions. A good indication of market risk is to simply examine the best and worst returns over one-year holding periods. Those returns were the kinds of variations that may occur within that category.

Stock market risk is due to the volatility of the overall market, which can cause even attractive stocks to drop in price. For one-year holding periods, stock returns were extremely volatile (and therefore uncertain)—ranging from a high of 52.6% to a low of -37.0%, a substantial loss. In addition, 23% of the one-year holding periods returns have been losses. Stock market risk does decrease with longer holding periods, as the long-term growth benefits kick in.

Bonds also face substantial market risk due to fluctuating interest rates; this risk is referred to as interest rate risk. Rising interest rates cause existing bonds to drop in value, while falling interest rates cause existing bonds to rise in value; the effect is greater the longer the maturity of the bond. Interest rate risk has caused intermediate-term bond returns to range between 29.1% and -5.1% for one-year holding periods, and suffer losses 12% of the time for one-year holding periods. Interest rate risk decreases only slightly as the holding period increases.

Cash investments face no market risk because their return is solely based on their current yield.

Inflation risk:
All investments face inflation risk—the risk that inflation will erode the real value of the investment. There are two good indications of inflation risk: an investment's real return (its return after inflation) and the percentage of holding period returns that are below inflation.

Stocks face the least inflation risk. Over the entire period, they have produced an annual real return of 6.7%. In contrast, bonds have outpaced inflation by only 2.0% annually, and cash by only 0.5%. Individual holding period returns also indicate the substantial inflation risk facing bond investments. For one-year holding periods, bond returns were below inflation fully 39% of the time; for longer holding periods, inflation risk was similar for bonds and cash.

Liquidity risk:
There are two kinds of liquidity risk facing investors. The first is an illiquid market—the inability to sell because of a lack of buyers. Real estate presents the best example: Houses may be on the market for months before a willing buyer appears. For the basic segments of the three investment categories, the markets are quite liquid—there are always willing buyers. The second kind of liquidity risk, however, is that you may be forced to sell at an inopportune time. For instance, if you must sell stocks to raise cash, you may be forced to do so when the market is low. The best indication of this risk for each category is to examine that category's worst return for a one-year holding period. In addition, you can reduce liquidity risk overall by investing a portion of your portfolio in cash, which doesn't face liquidity risk, lessening the chance that you must sell other investments in bad markets.

Table 2 presents a summary of the risks of the major investment categories.