Investment Risk Explained

Today, we'll be discussing the different types of investment risk. Hello, welcome to Money Talks. My name is Ken Wink from Summit Financial Consulting. If you'd like more info about what you hear during our show today, give us a call at 586-226-2100 or visit us online at our website, summitfc.net. While you're at the website, be sure to check out the podcast page. You can check out the old episodes and you can also subscribe on Apple Podcasts, Spotify, or Amazon Music. So this year has been a little bit of a hectic one. We've had some inflation that maybe was a little bit higher than expected. We've had tariff wars. We've had interest rates that didn't drop maybe as fast as everyone was hoping. Pretty volatile stock markets, some global uncertainty. I would argue there's never been a better time to just look at your entire portfolio and just see where it stands from a risk standpoint. So today we're going to be discussing the different kinds of risk, explaining them a little bit, and just see what we can do to maybe help improve your long-term chances of success. But before we drive in or before we dive in, let me bring in my co-host, Tony. Tony, I've been told that you are testing your own risk tolerance by drinking gas station coffee instead of your regular Starbucks. Is this true?

You know what, Ken? It's not true. I'm having a nice coffee right now from not a gas station. I try to typically avoid a gas station coffee, but I would drink coffee from a drive-in since you did mention drive-in in the opening instead of drive-in. But, you know, my dad was an over-the-road truck driver, and so I'd ride along with him in the summers when I wasn't going to school. And, you know, you hit every truck stop, and I got used to truck stop coffee. It builds character, right? Yeah. I think it builds character and a strong stomach, so I can... I have a resistance built up, but this topic you've got for us today, it's kind of a carryover, really. It's a continuation of our discussion from last week because investment risk is a little bit of what we talked about, but we didn't really dive into... Of the different types of risk. We talked about having your own personal risk tolerance and what you needed to do to stay diverse. But what are some of the risks that you want to discuss today?

Yeah, the first one is the biggest one that keeps us up at night for people that, I guess, don't have a proper financial plan. You know, I'm such a worrier, Tony. I'm worrying about the people that That aren't even our clients. But it's sequence of returns risk, and most people have never heard of it. So this is basically the risk that you retire at the wrong time. So just give me 30 seconds of math here, folks. Don't change that channel, just hang in there. Let's just say you had half a million bucks and you're taking 5% per year. Some people say you should take less than that, less than 5% per year. Let's just say you're taking 5% per year and that is generating $25,000 per year of income. And then all of a sudden, boom, a financial crisis happens. And, you know, this really happened in 2007 to 2009. People lost half their money if they were invested too aggressively. So your $500,000 is now all of a sudden $250,000. So rather than taking out 5% per year, you're now taking out 10% per year because the value of your account shrunk so much. So this is sequence of returns risk. This is how you become Mr. Unlucky and you just retired at the wrong time. There's a really good chance you're gonna have to go back to work or get a part-time job because the probability of that money getting back to where you want it to be It's pretty slim when you take a hit like that and you're drawing a monthly income. So either cut your expenses, cut your income, or get a job, unless the market just fires back up really, really quickly. But if you look at the chart of the S&P 500, it took almost five years for it to come back. So that was not a slingshot that people would need to not be crippled by sequence of returns risk. So this is why we feel so strongly that people should have a bucket plan. You wanna set aside your first five to 10 years worth of income in something that's safe. Or at least safer, relatively speaking, so that if the market has a big drop, you're not being forced to basically sell low. I mean, that's sequence of returns risk in a nutshell is you're forced to sell low because you retired at the wrong time and the stock market dropped on you.

Yeah. Well, a sequence of returns, you wonder, well, what does that mean? It's when you take money out when the market's down, right? And you have to constantly take money out to live on in retirement. So then you are at risk if you retire at the wrong time during a down year, during a down period, like you say. And it leads into what we talked about last week in managing risk. So you don't have that happen, diversification can help solve that sequence of return risk, right?

Yeah, yeah, if you're overly concentrated into one sector or one stock, that can definitely amplify and make sequence of returns risk even worse. And you know, people are asking, why are you guys talking about risk right now when the stock market's pretty much at all-time highs? It's had a good year overall. The last couple years have been good, actually. Like, things are going pretty well. Well, what goes up must come down. It might not be a bad time to take some profits and then set some of that money aside and something safe if you're depending upon your investments to live off for retirement. If you've got a pension and Social Security coming in and you're not really needing to pull from your investments, then sequence of returns risk isn't really a big concern for you unless there's something that might pop up unexpected, a new vehicle, purchasing a car, Investment property or a vacation property or maybe a health change. And now you need to go into a long term care facility, which can be pretty pricey. All of those things might might just make sequence of returns risk show up at your front door unexpected.

Yeah. Yeah. Well, if you only have the market to pull from, so you have to pull out money to live on when it's down. That's why we get into go back and listen to last week's show to figure out how to you don't have to do that is by diversifying and working with someone like Ken and your team there. Now, that sequence of returns risk. What's the next one? liquidity risk.

So unfortunately, in our industry, Tony, there are a lot of people who are not fiduciaries. So when you're a fiduciary, you have to do what's best for the client when you are not a fiduciary. And here in Michigan, the majority of financial advisors are not fiduciaries, according to our research a couple of years ago. Sometimes there are investments that pay very high commissions, and sometimes those investments are not very liquid, meaning you can't easily convert them to cash. So private equity, real estate, especially real estate investment trusts where, you know, it's one thing if you buy a house on the corner because you can always sell it. But if you do a real estate investment trust, somebody else is in charge of when it's sold, then you might be stuck for decades. Collectibles. My wife actually, um, had some old jewelry. I didn't get her. It was probably old boyfriends or, you know, nobody important.

Oh, nobody. I don't know about that.

Maybe, maybe passed down from her mom or parents. She, she wasn't actually sure if Nana and Papa gave it to her. I apologize to Nana and Papa, but, um, Anyways, the thing I wanted to point out is like there's the price of gold and then there's the price of what you can actually sell the gold for. And you're normally not getting it at the spot price because, you know.

Yeah. They got to make a living too.

Um, so these are all examples of, of non-liquid investments because you can't get to them easily. If you can get to them, there's a cost. So we, we as a firm don't love, uh, hard to sell investments.

There are certain financial record collection, my vinyl collection. I've got a lot of money tied up in it. Uh, you're saying that's a bad thing, aren't you? I wouldn't make that the cornerstone of your retirement plan now. Yeah. Yeah.

Yeah. So that's that's a big risk is whenever you're buying something that you're considering an investment, whether it's records, baseball cards, real estate, any type of, you know, collectibles are usually tough because whoever you sell them to typically wants to sell them to make a profit.

Right. You're not, you're not the end seller. You're selling them to a middle person. If you, especially if you're unloading a whole collection, right. Usually aren't collectors out there willing to pay full collection, collecting price for an entire collection. You could sell them one at a time online, but that costs money and takes a lot of time.

Right. So yeah, liquidity risk is a big thing to look out for. So anytime you're buying an investment and sometimes I got to call it an investment, um, Yeah. You got to make sure that you can quotes, you can offload it if, if needed to at some point.

Yeah. Yeah. I've tried to sell to my wife and kids that my record collection is an investment. Uh, they don't buy it. Can they're not, they don't, they don't buy it for a hot second. That didn't work at all. Yeah. And I don't view it as that either. It's a passion. So, uh, but it is, I have some records that I bought for, you know, 20 bucks that are now worth $500. Yeah.

Oh, wow.

Just for one record. So, yeah. Yeah. Records can be valuable if you take care of them and they're in great shape.

The most common thing that I see are people pass away and then their family are like, what are we going to do with these things? And they end up giving them to somebody who isn't final.

Yeah, yeah, exactly, exactly. Yeah, that's part of the problem. I mean, that's a gold mine when people find those though, and they're worth money at a guest, um, but good luck finding them at a Goodwill, because people know now that they can sell them online for money. So usually they don't make it out, the good ones don't make it out to the floor. Which one do you have that's worth 500 bucks? Holy cow. Well, I have a couple. I have a couple. There's a lot. I have a sealed Beatles Meet the Beatles from 1960. It's not an original press, but it is a mono, and it's sealed, and I got it from my second cousin or my mom's cousin. Got it from him. He passed, and I got his vinyl collection, and it was mostly terrible, right? But he had a couple of gems in there, so that's one of them. When you say sealed, does that mean like he just never opened it and listened to it? Yep. Yep. Still in the shrink. Yeah. Those are usually worth quite a bit of money as long as they're not warped. Sometimes if you left them in the shrink, that shrink would warp them and warped records aren't worth anything. Wow. And if they're too damaged, even the sleeve has damage or a sticker on it. Yeah, that's going to devalue it. Anyway, we're getting off the topic here. I always do that. You can't you can't bring up music or records with me or we'll be noted. It's like a huge train derailment for the show. Credit risk. That's another one, right? Yes.

Yeah. So anytime you own a bond, you have some risk and risk. It's tough because bonds have not done so hot the past five years or so. So there's a lot of people that are saying, you know what, I don't want to have anything to do with bonds. I'm just going to invest in stocks and sort of overload on stocks. So that's a separate risk. But credit risk, basically the whole idea behind credit risk easily explained as, let's just say that you have an investment. We'll say it's a bond and it's paying 3%. And then all of a sudden rates drop to 1%. Everyone says, oh gosh, New bonds are only paying 1%. I want your bond that's paying 3%. So that's an example of an opportunity. With owning a bond. On the flip side, there is, let's say that you own a bond that's paying 3% and then interest rates go up to 6%. Well, now nobody wants your crummy old bond that's paying 3% because I can get a brand new one that's paying 6%. So that's one part of the risk of bonds. So we describe that as interest rate risk. But then what you just mentioned, credit risk, that is basically the risk that whoever... You bought the bond from, they default. So when people buy a bond, a lot of times they don't realize that they're actually loaning someone money. You know, you give someone a thousand dollars for a bond, they agree to pay you interest, and then after a certain period of time, whether that's one year, five years, 10 years, 30 years, they give you back that thousand dollars that you loaned them. So, You want to make sure that whoever you're dealing with, whether it's a corporation or a municipality or even the U.S. government, that they've got a good financial strength rating. The ratings go from AAA, which is like the lowest risk, all the way down to junk status, which is in the Bs or worse. So you want to get as many A's as possible when it comes to your bonds, Tony, as far as avoiding credit risk is concerned. But You know, the United States government still has a pretty high rating, but I'm not so sure about loaning money to the U.S. government right now that the national debt's getting so out of control and the interest rates that they're paying are getting worse because a lot of the debt was issued back in the early 2000s around COVID when interest rates were in the, you know, close to zero and now they're much higher than that. So there's just a lot of Risk in the bond world. There's a lot of risk in the stock, you know, so, okay, I don't want bonds anymore. Like I said earlier, now you're over allocating the stock. Stocks have their own risks. PE ratios are very high right now, meaning that the price that you're paying for how much earnings you're getting from those corporations is, way above average. So that implies that maybe stocks are overvalued. So there's just a lot going on in the world today, Tony. You really got to keep an eye on your risk.

Well, yeah. And Ken, when we talk about bonds, they used to be a great safe option. You used to use the rule of thumb, 60% at risk, 40% in bonds, and that was your safety. But But your principal isn't protected with bonds, so it's not true safety. And that kind of went out the window after COVID. Bonds tanked. And I mean, bonds have not been the true safety and haven't kept up with inflation. And like 2022 proved that the stock market was way down and bonds were way down. Used to be when the stock market went down, bonds were usually typically up.

Oppositely correlated. Yeah.

Yeah. Oppositely correlated. And now they've been linked and that's not good. Right.

Yeah. It's a very risky environment right now. Yeah. Two more quick risks before we wrap up here. One is when you're looking at different investments and what they yield, don't just chase the yield blindly. So, you know, you could invest in junk bonds, which pay way more than U.S. government bonds. But guess what? They call them junk bots for a reason. There is some risk there. There is a chance that the company goes out of business and you actually lose your whole investment. So you got to make sure that you're doing proper due diligence and that your portfolio's sort of balanced to help mitigate that risk. There's also a ton of investments out there, Tony, where they will follow the price action of cryptocurrencies and high flying tech stocks. And then they pay these dividends. Like there are investments out there right now that Create call options and sell call options. And they're paying 40, 50, 60% annual dividend yield. Yeah. But then the price of the underlying shares is going down. So you're hoping that the dividends are higher than how much it loses each year. It's just sort of a It's a it's a very, very risky situation. And I have one client that's been following that strategy for the past two years. And at first he made a ton of money. Yeah. But now some of these high flyers are just getting killed.

And now, yeah, there are a lot of those so-called digital portfolios out there. Some of them have been really good. You know, there's a digital portfolio I know of that the first two years. I mean, the first year was like one hundred and seven. Percent, it was crazy, right? I mean, it was up a lot, um, and then the second year also really good, but then it had it down, then it started to go down again, so you can't put all your eggs in that basket either. Um, I, I don't think there's anything wrong with having, you know, tech stocks obviously, or even, even a digital discovery portfolio where it is tied to things related to cryptocurrency but not directly, you know what I mean? Sure. Uh, because yeah, but I mean, everybody's situation is different and what they need for risk is different. What's that? What's the other risk you wanted to talk about?

Um, just to rise in risk or, or like not the risk of not having an emergency fund. So just stuff can pop up, you know, you can lose your job, you could get disabled, you could get into a car accident, your spouse could pass away. Um, You know, there's ways that you can help mitigate that by having an emergency fund, by having insurance coverage, you know, maybe having a side gig that you could turn into a part-time job or a full-time job, but just unexpected events. You know, you want to make sure that you're... Prepared and able to sort of defend yourself financially if something unexpected happens so that you don't have to ruin your finances just to sort of survive.

So, yeah, if you're furloughed right now, a lot of federal employees haven't gotten a check in a month. Haven't been paid in a month or over a month. How are you going to survive when that happens? A lot of people are, most Americans don't have an emergency fund and live paycheck to paycheck. So that's really important, I think. And we've done, we talk about that a lot and we'll do whole shows on emergency funds. So that's important. Yeah. Well, hey, Ken, a lot of great information here. I'm sure our listeners out there and viewers have questions. How can they get a hold of you to set up that no charge, no obligation consultation to get their questions answered?

We'd love to help. Give us a call at 586-226-2100, or you can visit our website, summitfc.net. We would love to put together a plan together for you to figure out exactly how well prepared you are for all of the risks that we discussed.

All right. Sounds great, Ken. And listeners, that does it for today's episode of Money Talks with Summit Financial and our host, Ken Wink. Thank you for joining us for Money Talks. Don't head into retirement without a strategy that addresses both income and taxes. For more information, please contact Ken Wink at Summit Financial, working with people you trust. Call 586-226-2100 or visit SummitFC.net. Join us again soon for another episode of Money Talks.