Academics and finance professionals sometimes refer to the “risk-free rate of return” as a benchmark; in this context, the risk-free rate is the yield on cash assets, where you’re guaranteed stability of principal even as you pick up a slight (these days very slight) return.
But despite the ubiquity of the term “risk-free rate,” no investment is 100% free of every possible risk. Even while assets parked in CDs and online savings banks won’t fluctuate in value, the investor who parks too much in them can face other types of risks, including inflation risk and shortfall risk. Meanwhile, stocks have a much higher level of risk in the conventional sense, in that you could lose all your money and never recover it. At the same time, an investor who buys and holds a mostly stock portfolio generally faces less of a shortfall risk than the investor who parked the same amount in cash over several decades.
Because each and every investment type entails at least some type of risk, investors would do well to make sure they understand the key risk factors associated with each asset class, build portfolios well diversified across the asset classes (and, in turn, risk factors), and don’t take more risk than they can afford to, given their time horizons.
Here’s an overview of some of the key risks associated with each asset class. Note that some of these risks cut across asset classes – for example, valuation or price risk is primarily associated with holding stocks, but it can affect bond investors too.
Cash & cash-like investments
Inflation risk: One of the big risks for investors in fixed-rate securities – especially ultra-low-yielding securities like cash – is that their investments may not earn enough to keep up with inflation over time. That’s certainly a big risk today: cash yields are mostly under 1% right now, but the Consumer Price Index is running in the neighborhood of 1.7%. That means that investors that are holding too much cash today aren’t even preserving their purchasing power. The longer the holding period, the more inflation risk should be a concern.
Shortfall risk: Investors can fall short of their financial goals for many reasons - key among them is under-saving. But if you’re saving for a long-term goal, holding too much in investments with little to no short-term volatility – but commensurately low returns – can help exacerbate shortfall risk.
Next time: risks in bonds, foreign bonds and US stocks.