Take the time to study the risks inherent in your investments, in mutual funds and other security products, required disclosures in fund literature can help determine fees, commissions and cost of ownership, along with other points that may help you find if there’s anything amiss that could derail your goals.
But beyond the literature, other basic portfolio risks include:
1. Interest rate risk: Its a good idea to get familiar with a complicated measure called duration, which indicates the sensitivity of a bond or bond fund to a change in interest rates.
The longer the duration — expressed in years, as maturities are, but not the same — the steeper the price decline as rates rise (and vice versa). Unfortunately, high credit quality does not protect you from a plunge in prices of long-term issues.
2. Currency risk: In addition to the risks they share with domestic stock funds, world equity funds pose the risk that a rise in the U.S. dollar’s value against other currencies could cause returns on foreign stocks, expressed in local currencies, to suffer when translated into greenbacks.
3. Investment style risk: Growth-stocks and ETFs are expected to own stocks that can grow faster than an economy, while value stock funds are supposed to buy stocks that sell at discounts to an estimate of their true value. These are called “style” funds.
Owning a growth fund when value funds are hot (or vice versa) — that is, being invested in an out-of-favor investment style, then rushing to an in-favor style leader, and then switching to keep up with style leadership rotation is a recipe for high trading costs and possibly investment losses.
The landscape changes frequently, as indicated by Russell growth and value stock indices, classified according to capitalization. If you believe your portfolio is underexposed to either style and want a growth or value fund to correct that, why not plan to hold it as long as its performance is satisfactory?
4. Unsuitable investment risk: When securities markets offer low bond yields, volatile equity returns, or both, you may be tempted by investments that appear to meet your needs but are in fact unsuitable.
Cash dividends from well-chosen stocks have a good chance of rising over time, but a bond’s payment is fixed till maturity. Moreover, pocketing capital appreciation from bonds would require lower interest rates, which is an unlikely prospect at this point.
For a private discussion on your portfolio, contact Tom Cooper.