The Four Types of Risk
by Charles Rotblut | April 06, 2023
The U.S. financial markets and our office will be closed tomorrow for Good Friday. Wishing a happy Easter, a happy Pesach and Ramadan Mubarak to those of you observing the respective religious holidays.
In this month’s AAII Journal, we provide an example of a one-page PRISM Wealth-Building Plan for a millennial investor wishing to save for retirement. Included in it is a revised framework for assessing risk. The revision incorporates feedback from AAII members about the wealth-building process.
The simplistic view of risk is the chance of losing money. This viewpoint does not, by itself, work well in the realm of financial planning and investing. Rather, a more complete view is needed—one that encompasses four different types of risk: systematic, behavioral, sequence and inflation.
Systematic risk is the chance of broad market and macroeconomic events leading to a loss. All asset classes incur systematic risk (e.g., dollars can be devalued relative to other currencies). Growth assets like stocks compensate you for systematic risk with high long-term returns. Diversifying across different asset classes helps to reduce the systematic risk associated with a single asset class. The trade-off for diversifying away from growth assets to reduce their systematic risk is lower long-term returns.
Behavioral risk is the chance of forfeiting wealth by making bad decisions. Such decisions include reacting to downward market moves or adjusting your allocation based on what you think is going to happen. Of the four risks, this is the only one you can control. Having a written wealth-building plan, buy and sell rules or just a checklist can help you reduce behavioral risk.
Sequence risk is an ill-timed drop in the markets, particularly occurring when or just before withdrawals are needed. Stocks and commodities are the asset classes most prone to sequence risk. Investors with long time horizons should embrace sequence risk because a drop in prices allows you to buy more of an investment with each dollar saved. Investors who are nearing the time when withdrawals will be needed should boost their allocation to so-called safe assets (money market funds, short-term bonds, etc.) to avoid having to sell more volatile assets (e.g., stocks) when their prices are down.
Inflation risk is the chance of losing purchasing power. Purchasing power is the ability to buy goods and services with dollars you have. Inflation is typically a small risk over short time horizons (2022 not withstanding), but a major risk for investors with long time horizons. Exposure to growth assets like stocks offsets inflation over the long term. Treasury inflation-protected securities (TIPS) can also provide some help on the bond side. Over the short term, saving more and reducing spending helps to offset inflation risk.
These four types of risks should not be viewed in isolation from each other. If your time horizon is long (e.g., 15 years or more), embracing systematic risk by allocating heavily to stocks allows you to both overcome inflation risk and be able to ride out bouts of sequence risk. If your time horizon is short, sequence risk is a bigger threat and calls for limiting exposure to the systematic risk of investing in equities. Behavioral risk plays a role in both. For long time horizons, you must take your ability not to react to shorter-term downside volatility into consideration. For the short time horizons, you must be comfortable sacrificing potentially higher short-term gains to avoid incurring a large short-term loss.
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A One-Page Wealth-Building Plan to Reach the Goal of Retirement
A good plan with enough guidance to help an investor align their investment decisions with their goals can be written on a single page. -
Using Your Portfolio's Asset Mix to Control Your Risk
Once you know your risk capacity, you can make adjustments to your portfolio to arrive at the optimal allocation for you. -
Learning to Manage the Myriad Risks in Your Portfolio
If recent events have raised your stress levels, now is the time to review your portfolio for any of the potential risks. -
Measuring Performance 10 Years at a Time
Over the course of rolling 10-year returns since 1926, the performance of three multi-asset portfolios could be similar, widely different and then similar again. -
Stock and Bond Yields Are Converging
The earnings yield is frequently used to assess the valuation of stocks compared to the valuation of bonds.
Members are looking for your input. Can you help with this question from the Mutual Funds & ETFs Community?
“What has been your experience with high-yield bonds and funds? Are these investments something you are allocated to right now during rising inflation, or have you tapered off because they carry too much risk?”
Tap the button and then choose the Join the Community button on the right to answer this question in the AAII Community
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AAII Sentiment Survey
Pessimism among individual investors decreased but remained above average for the seventh consecutive week. Neutral sentiment decreased slightly, while bullish sentiment rose.
Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 10.8 percentage points to 33.3%. After being unusually low for the past six weeks, optimism found its way back closer to its average. However, bullish sentiment is still below its historical average of 37.5% for the 70th time out of the past 72 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, decreased by 0.3 percentage points to 31.6%. Neutral sentiment is above its historical average for the 13th time out of the past 14 weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, fell 10.6 percentage points to 35.0%. After being unusually high for the past five weeks, pessimism is now at a seven-week low. Still, bearish sentiment remains above its historical average of 31.0% for the 67th time out of the past 72 weeks.
The bull-bear spread (bullish minus bearish sentiment) increased 21.4 percentage points to –1.7%, ending its six-week streak of being unusually low.
The improvement in optimism occurred as the S&P 500 index bounced back from its recent lows. In addition, individual investors mostly approved of the smaller interest rate hike announced by the Federal Reserve a few weeks ago. Inflation along with market volatility and the pace of economic growth continue to influence individual investors’ short-term outlook for stocks.
This week’s special question asked AAII members how the headlines about banks have affected their six-month outlook for stocks. Here are their responses:
- They are not influencing my outlook: 26.5%
- They are making me more cautious: 41.5%
- They are making me more optimistic: 4.4%
- No direct effect yet, as I am waiting to see how things evolve: 27. 7%
Bullish: 33.3%, up 10.8 points
Neutral: 31.6%, down 0.2 points
Bearish: 35.0%, down 10.6 points
Bullish: 37.5%
Neutral: 31.5%
Bearish: 31.0%
See more Sentiment Survey results.
AAII Asset Allocation Survey
Individual investors’ exposure to fixed income rose to a 17-month high last month. The March AAII Asset Allocation Survey also shows higher cash allocations and a pullback in equity exposure.
Stock and stock fund allocations fell by 1.0 percentage points to 64.7%. The decline ends a four-month streak of rising equity exposure. Nonetheless, stock and stock fund allocations are above their historical average of 61.5% for the 34th consecutive month.
Bond and bond fund allocations rose 0.2 percentage points to 15.1%. Fixed-income exposure was last at this level in October 2021. Bond and bond fund allocations are below their historical average of 16.0% for the 25th consecutive month.
Cash allocations rebounded by 0.7 percentage points to 20.1%. Cash allocations are below their historical average of 22.5% for the fourth consecutive month.
The increase in fixed-income allocations occurred as Treasury bond yields pulled back from their recent highs. The decline in equity allocations occurred as bullish sentiment in the weekly AAII Sentiment Survey fell to historically low levels last month.
- Stocks and Stock Funds: 64.7%, down 1.0 percentage points
- Bonds and Bond Funds: 15.1%, up 0.2 percentage points
- Cash: 20.1%, up 0.8 percentage points
- Stocks: 30.9%, down 0.5 percentage points
- Stocks Funds: 33.9%, down 0.5 percentage points
- Bonds: 4.2%, down 0.0 percentage points
- Bond Funds: 11.0%, up 0.2 percentage points
- Stocks/Stock Funds: 61.5%
- Bonds/Bond Funds: 16.0%
- Cash: 22.5%
Take the Asset Allocation Survey.
March 30, 2023 Remembering AAII's Derek Hageman
March 23, 2023 March Charts of Interest
March 16, 2023 Banks Behaving Badly, and How Your Accounts Are Insured
March 9, 2023 Both Small-Cap and Large-Cap Stocks Rebound Strongly
Discussion
Barry from TX posted over 3 years ago:
I see another two types of risk missing from this “portfolio” of risks. Portfolio management – as AAII PRISM teaches it - seeks to deal with market risk (“beta”) and portfolio risk (“sigma”). Rebalancing your portfolio can only address these types of risks. There are BIGGER RISKS lurking behind the 4 risks in this article. They are the risks of WHAT, WHO, and WHY the levels of risk impacting markets and our portfolios are increasing. And why NOW? The level of risk began to increase AFTER investors had made our portfolio allocations to mitigate a level of risk at a PRIOR time period. Now we are being advised to deal with problems we did not create and to make more decisions to anticipate an unstable, unpredictable future state these same external forces - the WHATs, the WHOs, and the WHYs - are continuing to create. How do you rebalance for an uncertain future with unknown NEW risks from the same sources? Rather than rebalancing our portfolio asset selections and diversifying to fight potential market risks, maybe we need to "rebalance" -- or remove - the causes of these BIG RISKS. Removing the sources of these known risks would seem to be a more effective approach than "living with" the problems created by these known sources.
John L from NJ posted over 3 years ago:
Inflation is not a risk. It is a certainty. I am retired now and in my life, so far, I have never experience deflation; just inflation. Mostly low single digit inflation but also periods of high inflation like in the 1970's, 1980's, and recently. The Federal Reserve has failed for over 100 years to maintain the stable value of the dollar and there is no reason to believe they will improve in the future.
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