Have you considered these 5 Investment Risks?

Everyone knows investing can be risky, however somehow we believe that we have the knowledge and awareness or simply pure luck to avoid the vast majority of risks.                                          

Any investment decision we make should be proceeded by much consideration before plunking down our money. If like most people, you don’t have the time or the expertise, it shouldn’t prevent you from asking questions and getting real answers. Let’s consider these five types of risks that may have not come to mind.

1.  Concentration risk or Overlap: Even we invest in multiple mutual funds that have different investment objectives we may find that we invest in the many of the same companies. 

Retail Fund managers have a similar goal; the highest performance possible regardless of where they invest. It isn't uncommon to find small cap holdings in a large cap fund or a growth company in a value portfolio. Overlap creates additional risk by reducing diversification and putting more weight on those companies in higher concentration, therefore creating a greater risk overall.                            

This may not be always obvious without really digging to find out the level of overlap.                        One way to avoid it is when we’ve reach a certain level of assets or station in life that merits having an institutional service where our chosen assets managers are using separately managed accounts instead of simply choosing mutual funds. By doing so we can benefits from lower trading costs and more importantly, our asset managers can be aware of any overlap.

2. Interest rate risk or duration risk: Most people assume that Bonds are safe! 

Bonds are safe. Right? Well, not always. In order for mutual fund managers to get better returns (higher rates), they may choose fixed income securities with longer durations.This might sound like a reasonable strategy, however when ever there is an upward trend toward higher interest rates, it will create devastating losses in those seemingly “safe” investments. 

Investors do not get paid back for the risk involved in buying long-term bonds. 

Research shows that over the long term the amount of risk is disproportionate to the expected return. This may be especially true now since the Feds may decide at any time in the near future that the economy has strengthened enough to put a halt to purchasing their own debt and suppressing interest rates, which in turn they hoped with stimulate business growth. 

3. Hidden Costs: Broker are required to deliver a prospectus, but unless we read it carefully, it’s very difficult to determine exactly what an investment really costs. If we buy a fund that does a lot of hedging and derivatives, our costs may increase a notch or two. The farther we get from plane Vanilla flavored fund like an S&P 500 Index, the higher the expected costs can rise in order to account for increased research and operational costs. We need to ask whether our expected return is great enough to take on the greater costs involved.                                   

We may find additional hidden costs. According to a 10/1/2010 Wall Street Journal article by Anna Prior quoting a study co-written by Richard Kopke, an economist at the center for Retirement Research at Boston College, trading cost not that are reported in mutual funds expense ratio averaged 0.14% to 2.96%. according to the  study, four components added to the cost: 

Brokerage commissions, Bid\Ask spreads, Opportunity cost and Market cost impact. 

The study looked at the 100 largest stock funds held in defined contributions plans. 

Some of us measure value by how much we put in our pocket however the bottom line may not be the only way we should judge value the closer we get to retirement. This is when our need for safety and preservation may outweigh our younger year’s need for accumulation. However how much we gain is still part of the consideration. 

4.  Taxes: More people can expect to pay more in taxes with the Medicare surtax of 3.8%. 

This increases the importance of tax conscience investing. 

Investors who participating in actively managed mutual funds might find an expected and unpleasant result when managers who are eager to show wins produce short-term gains regardless of the nature of the fund we choose and we only uncover the true cost when our tax bill is due. 

Funds with higher turnover are more likely to produce more short-term gains.

If we are at or near the higher brackets, we may need to be more aware of the consequences or the short term wins since they may create a big (tax) loss.

5. Subjectivity can be a hazardous:  Fund managers like us, have biases. They might be looking at the world through a small cap perspective or they may tend to lean toward value investing, but a personal or a professional bias can lead to a skewed result. If all you have in your tool box is a hammer, everything may look to you like a nail. When choosing a mutual fund, we need to be aware of the biases and attitudes that fund managers possess towards stock picking. If we want to have wide diversification and the experts we use see the world in the same way, our portfolio might lack dimension and breadth. This means, we need to be asking questions before investing and make sure the actions of the funds managers match the words or the answers we got.

Risk is unavoidable and it is everywhere. It makes knowing the types of risks that exist and it requires that we have greater understanding in order to help us make informed decisions that are in line with our needs, wants and goals in order to reach our objectives.

Graphic from forbes.com/billharristhesevendeadlyinvestorsins2/7/13