Risk Explained for Idiots and Dummies

OK, I am back to my Saturday semi-series “Investing for Complete and Utter Idiots (and Dummies Too)” after a couple weekends of not being able to find something I am actually capable of breaking down into simple terms.  It was so simple and staring me in the face in my comments section the whole time.  LOL

A couple weeks ago when I broke down the federal and military Thrift Savings Plan, kentuckyliz left a comment about my remark that bonds are “low risk.”  She said:

Bonds are less risky? Low risk? You do not understand risk. Bonds are highly risky because over time, inflation eats their lunch. You lose purchasing power. For long term investing, the biggest risk of all is outliving your money, and the chances of doing that are higher if you invest in bonds.

Actually, I do understand that there are two types of risk, but most people are only familiar with one, so that was the form of “risk” I was referring to.  I should have been more specific, but if I had I wouldn’t have something to write about this morning.

The most common idea of risk is the possibility of losing money in an investment.  Right now this one is center stage for most investors, given the volatility of the markets.  I’ve previously described the stock markets’ volatility as similar to watching someone dribble a basketball: up, down, up, down, etc.  You could buy into a fund right now, and if the markets have a bad week your investment would be worth less than when you bought it.  This is the kind of risk most people talk about and fear, that they will lose money because the stock markets went down.

But as kentuckyliz pointed out, there is a second kind of risk, waiting in the wings and its name is inflation, and its kissing cousin stagflation.  People in their forties or older are familiar with this one, having lived through the 1970s and early 80s when it was a huge problem.  Inflation simple means the cost of things go up (”inflate”), and seems to always be present in some form or another.  As long as inflation numbers are low, and wages go up with them, most fancy-pants economists don’t worry about it.  The risk inflation poses becomes a problem when the rate of return on an investment is lower than inflation.

It’s like a race between what you earn in your investment and the inflation rate.  If inflation gets ahead of your investment, then mathematically you are actually losing money.  This was kentuckyliz’s point about the true risk of bonds.  If you aren’t earning enough to be ahead of inflation, the money you earn doesn’t buy as much as it did before you invested.

We’re all familiar with inflation, whether we realize it or not.  Look at the cost of a gallon of gasoline for your car and the cost of a gallon of milk.  When I first got out on my own, you could buy a gallon of either one for less than $2.  Now, a gallon of milk for me last week was $3.49 (and I was happy to find that price!) and a gallon of gas yesterday was $2.82 (and I was extremely happy to find that price to fill up the Pizza Taxi!).  When I got out on my own in 1991, a gallon of gasoline was $1.22 and we were fussing about that since it had been $0.88 the previous summer.  A gallon of milk was about $1.49 on a good day.  Of course, minimum wage at the time was $4.25 per hour, and it just recently went up to $5.85 per hour.  That’s an example of inflation at work.

Of course, the “official” way to figure inflation, according to what I have read, leaves out food and energy costs.  I’m still scratching my head over that one, since food and transportation are considered necessities in some form.  Does anyone know why that is?  Or is this a case of the government making its own standards and rules to make things look better?

Either way, there’s the two forms of risk: directly losing money in an investment because its value has gone down, and the way inflation will eat up the returns on a “low risk” investment.  No matter how little you and I know about investing, we still have to watch out for both kinds of risk.  To use a football analogy, you have to not only watch out for the front line blitz, but you also have to watch out for the blind-side tackle, and that blind-side tackle is inflation.