“One overlooked pitfall of retirement planning that can wreak havoc on your portfolio is “uncompensated risk.”- Gary Stewart
Even the least sophisticated investors accept that higher rewards aren’t possible unless one is willing to take more risks.” No risk, no gain” is one of the most widely-accepted tenets of modern investing.
However, financial academics and other people who love data and formulas love to point out that the idea of making more money in the markets by taking on greater risk doesn’t always ring true.
The market can be exceptionally fickle, refusing to reward your fearless investment strategies. Sometimes, greater risk may decrease, rather than increase, expected returns. Risky bets that don’t pay off are known as “uncompensated risk.”
The continuum of risk and reward
When discussing an asset’s risk, financial experts usually mean how volatile or subject to price changes that investment is. On a personal level, risk also refers to the potential of losing some or all of one’s money.
Various asset classes such as bonds, cash, real estate, equities, precious metals, and other investments are somewhat precariously perched on a continuum of risk and reward.
For example, cash is perhaps the least risky of all asset classes. You generally don’t expect to get high returns from it. Another favorite low-risk asset is bonds. Bonds carry greater risk than cash but have historically higher returns.
Equities, such as stocks, have typically delivered higher returns than either cash or bonds. In the long term, most investors rightly expect stock returns to crush cash returns. As a result of this expectation, stocks are usually the riskiest mainstream asset class.
Offsetting uncompensated risks
A commonly-cited example of uncompensated risk is when an investor purchases shares in an individual company instead of putting money in the broader market.
For example, suppose you liked the ZXY Widget Company, expecting it to deliver a 12% annualized return over the next ten years. You also believe that the market will return 12% in the next ten years. You decide that, since the risk of investing with one company versus the entire market appears to be the same, you’ll keep things simple and put all your eggs in the ZXY Widget Company. But, you may have forgotten that ZXY could suffer a host of incidents that prevent it from realizing those 12% gains.
For example, the company could:
- Have an accident or be involved in a massive lawsuit.
- Manufacture a product that suddenly becomes obsolete. (8-track tapes, anyone?)
- Have a leadership meltdown that impacts profits.
- Go bankrupt.
Of course, the broad market will also have its ups and downs. However, the idea is that all companies won’t be experiencing the same adversities simultaneously.
Thus, if you have all your money sitting in one stock, you take on more risk than the market. You might lose all of your money. Holding more than one company creates immediate diversity, thus reducing this risk. Of course, the more different companies you have in your portfolio, the more remarkable that diversity.
Summing it up: Uncompensated risk is a common but not entirely necessary threat to a person’s financial future. Your financial advisor can help you create a portfolio that reflects your risk tolerance and long-term goals. Creating a robustly diverse portfolio including safe money products such as annuities may help offset risk and ensure more success in retirement.