Investments are labeled as aggressive or risky that have been susceptible to wild price fluctuations in the past. The presumed uncertainty and unpredictability of this investment's future performance is perceived as risk. Investments deemed more conservative historically have moved within a narrower range of peaks and valleys. Unfortunately, this explanation is seldom offered, so it is often unclear whether volatility gauge is being used to measure risk.
Before exploring risk in more formal terms, a few observations are worthwhile. On a practical level, we can say that risk is the chance that your investment will provide lower returns than expected or even a loss of your entire investment. You are probably also concerned about the chance of not meeting your investment goals. After all, you are investing now so you can do something later (for example, pay for college or retire comfortably). Every investment carries some degree of risk, including the possible loss of principal, and there can be no guarantee that any investment strategy will be successful. That's why it makes sense to understand the kinds of risk as well as the extent of risk that you choose to take, and to learn ways to manage it.
What you probably already know about risk
Even though you might never have thought about the subject, you're probably already familiar with many kinds of risk from life experiences. For example, it makes sense that a scandal or lawsuit that involves a company will likely cause a drop in the price of that company's stock, at least temporarily. If one car company hits a home run with a new model, that might be bad news for competing automakers. In contrast, an overall economic slowdown and stock market decline might hurt most companies and their stock prices, not just in one industry.
However, there are many different types of risks to be aware of. Volatility is a good place to begin as we examine the elements of risk in more detail.
Other types of risk
Here are a few of the many different types of risk and how each can impact your TSP Investment funds.
· Market risk (F-fund, C-fund, S-fund, and I-fund): This refers to the possibility that an investment will lose value because of a general decline in financial markets, due to one or more economic, political, or other factors.
· Inflation risk (G-fund): Sometimes known as purchasing power risk, this refers to the possibility that prices will rise in the economy, so your ability to purchase goods and services would decline. Inflation risk is often overlooked by fixed income investors who shun the volatility of the stock market completely.
· Interest rate risk (F-fund): This relates to increases or decreases in prevailing interest rates and the resulting price fluctuation of an investment, particularly bonds. There is an inverse relationship between bond prices and interest rates. As interest rates rise, the prices of bonds fall; as interest rates fall, bond prices tend to rise.
· Reinvestment rate risk (F-fund): This refers to the possibility that funds might have to be reinvested at a lower rate of return than that offered by the original investment.
· Default risk (F-fund): This refers to the risk that a bond issuer will not be able to pay its bondholders interest or repay principal.
· Liquidity risk (F-fund, C-fund, S-fund, and I-fund): This refers to how easily your investments can be converted to cash, or more precisely, how easily your investments can be converted to cash without significant loss of principal.
· Political risk (G-fund, F-fund, C-fund, S-fund, and I-fund): This refers to the possibility that new legislation or changes in foreign governments will adversely affect companies you invest in or financial markets overseas.
· Currency risk (I-fund): This refers to the possibility that the fluctuating rates of exchange between U.S. and foreign currencies will negatively affect the value of your foreign investment, as measured in U.S. dollars.
The Relationship between risk and reward
In general, the more risk you're willing to take on, the higher your potential returns, as well as potential losses. This proposition is probably familiar and makes sense to most of us. It is simply a fact of life — no sensible person would make a higher-risk, rather than lower-risk, investment without the prospect of receiving a higher return. That is the tradeoff. Your goal is to maximize returns without taking on an inappropriate level or type of risk.
Understanding your own risk tolerance
The concept of risk tolerance is twofold. First, it refers to your personal desire to assume risk and your comfort level with doing so. This assumes that risk is relative to your own personality and feelings about taking chances. If you find that you can't sleep at night because you're worrying about your investments, you may have assumed too much risk. Second, your risk tolerance is affected by your financial ability to cope with the possibility of loss, which is influenced by your age, stage in life, how soon you'll need the money, your investment objectives, and your financial goals. If you're investing for retirement and you're 35 years old, you may be able to endure more risk than someone who has been retired for 10 years, because you have a longer time frame before you will need the money. With 30 years to build a nest egg, your investments have more time to ride out short-term fluctuations in hopes of a greater long-term return.
Reducing risk through diversification
Don't put all your eggs in one basket. You can potentially help offset the risk of any one investment by spreading your money among several different asset classes. Diversification strategies take advantage of the fact that forces in the markets do not normally influence all types of investment assets at the same time. Diversification cannot guarantee a profit or ensure against a potential loss, but it can help you manage the level and types of risk you face.
In addition to diversifying among asset classes, you can diversify within an asset class. For example, the stocks of large, well-established companies may behave somewhat differently than stocks of small companies that are growing rapidly but that also may be more volatile. A bond investor can diversify among Treasury securities, more risky corporate securities, and municipal bonds, to name a few. Diversifying within an asset class helps reduce the impact on your portfolio of any one particular type of stock, bond, or mutual fund.
Risk and the TSP
For many, the Thrift Savings Plan is a retirement plan, and it is; however, it is also an investment program, and it needs to be treated as such. Participating in the TSP involves investment risk, and as an investor, you need to be aware of the risks associated with each investment option. The points discussed in this newsletter are ones that you can use to help manage your funds. You can also find more information on the risk associated with the funds on the TSP website.
James De La Torre has conducted federal benefit and financial planning seminars all over the country. He is a keynote speaker at federal conferences and works with federal professional organizations on ways to improve the communication of federal benefits to their membership. Jim has appeared as a guest on “Fed Talk” on the Federal News Radio network, discussing the gaps in federal benefits and the financial impacts employees face. Jim holds a Charter Retirement Planning Counselor’s (CRPC) designation from the College of Financial Planning, and is a member of the Financial Planning Association. Please direct questions or comments directly to James at firstname.lastname@example.org.