The 4 Great Risks to Your Investment Portfolio

All right, I promised you at the top of the podcast that we would talk about risk today. And there's a real problem in the financial world in that risk is often equated to volatility. You know, your investment's going up in value, going up and down in value, going up, going down. And that's what risk is, often in academic papers and academic journals. But honestly, that doesn't really matter all that much if you're investing for a goal that's 30 years out. Does it really matter what the volatility is between now and then? So long as you can control your behavior enough to not do something stupid because of that volatility, then it really doesn't matter. Right? That's not true risk. True risk is the permanent loss of capital, you know, where it's not going to bounce back. Now you've got that risk if you've decided to run the undiversified risk by investing in something like individual stocks, right? Individual stocks can and do go to zero all the time. But if you're investing in an entire market via an index fund, that risk just really isn't there, barring an Armageddon type scenario. So the real risks in your portfolio, if you have a portfolio of broadly diversified index funds, the real risks are the Four Horsemen of the Apocalypse, as Dr. Bernstein has described them. The first and most common one is inflation. And inflation's a big deal. Not when it's 3% necessarily, although you do need to set up your portfolio such that you can overcome that sort of low rate of inflation that's pretty typical in today's financial societies. The big risk is that inflation gets out of control. Now, we all understand this a little bit better now than we did five years ago. Our inflation in this country, as measured by the Consumer Price Index for urban consumers, peaked at just over 9% a couple of years ago. And at 9%, your wealth is really being eroded pretty darn rapidly. And so I was pleased to see the Federal Reserve take pretty significant steps to try to rein that in. They can be criticized, and maybe they should have done it a little bit faster, but at least they acted aggressively when it became time to act aggressively. Now, that's caused a lot of pain. It's caused pain in the real estate markets, both for investors as well as people trying to buy houses using credit. It's caused pain for businesses that haven't been able to get the credit as easily as they would like to because interest rates went up 4%. But I assure you that all the pain in Society now, due to increased interest rates, are far less than the pain we would have if we had let inflation continue to be out of control. All you have to do is look at a society like Argentina and what they're dealing with right now. They're literally having votes trying to decide whether to even use their own currency. They may just start using ours because it's viewed as being more stable. Hyperinflation's a real risk. It's the most common of these four horsemen of the apocalypse. And your portfolio should be designed to withstand it. And you can do that by having a healthy allocation to assets that typically beat inflation. Things like stocks and real estate, things with higher returns than inflation has typically been. On the fixed income side, you can do things like keeping your durations short, okay? So that reduces your risk should interest rates need to be increased rapidly. And it helps you get the current going rate on those interest rates. Also, you can get inflation indexed. Bonds, you can get I bonds, you can get tips. Those sorts of things help you to keep up with inflation. Sometimes people make an allocation to other items in their portfolio, typically speculative assets. These might be commodities. It might be precious metals like gold or silver or platinum. It might be a crypto asset asset like Bitcoin. I would encourage you to limit your allocation to those sorts of speculative investments, but they can play a role in beating inflation. The next of the four horsemen is deflation. And the classic scenario historically to think about this is the Great Depression, right? This is a time of economic contraction and it really did a serious number on people's wealth. Now, those with long term bonds actually did pretty well in a deflationary scenario. But equities dropped 90%. Properties dropped dramatically. Some insurance companies didn't pay as they were supposed to. A number of banks failed. This is a real risk to your wealth to go into a real period of deflation. The next one is confiscation. And we all think we're dealing with confiscation every April 15th. And I suppose in some small way you are. But governments can do much more than what our government does to us. April 15th of each year, they can increase taxes dramatically. There are some societies in our world that have tax rates of over 50%. And they can go higher and higher and higher. In addition to that, sometimes private assets are simply taken by the government. I mean, you've heard the phrase eminent domain, right? They're going to put a freeway through and they can just seize your house. Typically, the fair thing to do is pay you market value for the house. But there's no guarantee that the government will actually do that. If you look at a period like 1918 in Russia, basically this communist revolution took place, and people just lost their private assets. They were confiscated by the government. Serious risk, difficult to protect against, not nearly as common as inflation. But you can see why some people do things like put a little bit of their money into Bitcoin. The idea being that maybe you can hide that from the government in a confiscatory scenario. The final big risk to your portfolio is devastation. Just widespread economic, political, social devastation. Imagine you're in Germany at the end of World War II or Japan at the end of World War II, and your cities have just been firebombed. Someone's dropped nuclear bombs on the cities in your country. GDP is dramatically contracted, and it's just. It's devastating, right? Your entire house has been blown up, and no. No insurance company is going to rebuild it. That's a true risk. Very hard to defend against, right? I mean, I guess you can spread assets out in multiple countries across the world, but even then there are no guarantees. But when you think about risk, those are the big risks in your life. It's not the little risks you see when you're, you know, looking at some financial study that shows a little bit of volatility of your investments. So keep that in mind as you invest. Try to deal psychologically and emotionally with your volatility, putting it in an appropriate place. But keep in mind what the true risks are to your financial life.

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.