Risk comes in two major flavors: short-term and long-term. With investments, short-term risk comes from the investments themselves—where they sit in the corporate capital structure. When a company generates cash, there are three different types of claims on that cash: senior claims (bonds), operating claims (real-estate), and residual claims (equity). The volatility of the cash-flow and the priority of the claim determine the likelihood of the investor getting his or her money back.
But long-term risk comes from outside the investments—from the economic environment. It takes four major forms: inflation, depression, confiscation, and devastation. Of these four, inflation is by far the most common. Confiscation—by unexpected taxes or by other means—is less common. Devastation by war or natural disaster even less so. And depression and deflation is the least common.
The best hedge against unexpected inflation are stocks. They tend to grow in real terms even in hyperinflationary environments. Foreign assets protect against confiscation and devastation, especially foreign real-estate. And bonds protect against deflation and depression. Sensible asset allocation takes all these factors—and their likelihood—into account.
Your investment horizon should determine the kind of risk you needs to manage. A short horizon calls for short-term risk management. Whatever your risk is, your investments should match it.
Douglas R. Tengdin, CFA
Chief Investment Officer