There are three basic portfolio risks that can prevent investors from achieving their goals, retirement and otherwise, according to Manning & Napier, including capital risk, reinvestment rate risk and inflation risk.
Capital risk needs to be actively managed based on the current market and economic environment, according to Manning & Napier. The company pointed out that since many investors believe that equities outperform fixed income securities over the long run they may invest the majority of their portfolios in equity securities.
And even though long-term average annualized returns have been between 9 percent and 10 percent since 1926, there is a high chance that stocks may fail to earn reasonable returns over periods of time as long as 10 years, Manning & Napier found. For example, the S&P 500 failed to provide a 5 percent annualized return in about 17 percent of rolling five-year periods and a 10 percent annualized return in about 49 percent of rolling 10-year periods from 1926 to 2013.
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From 2000 to 2009, the 10-year cumulative total return of the S&P 500 was -9.01 percent. So the equity markets can go through extended periods where they fail to provide returns sufficient to meet an investor's long-term goals, Manning & Napier concluded.
Investors need to understand that the forward returns of equity markets are dependent on the current environment. Equity securities purchased during speculative market peaks and at lofty valuations have historically provided lower returns going forward than those purchased when valuations were lower, Manning & Napier found. Also, in the past, higher market price-to-earnings ratios have typically led to lower future 10-year returns.
While investors most often consider Capital Risk as it relates to their equity investments, it is important to recognize that sustained losses can also occur in the fixed income markets, it found. For example, investors in need of income yield that have moved toward high-risk speculative-grade securities in the face of the current low interest rate environment should recognize the increased risk of default in these securities.
However, if investors were to allocate a large portion of their investments in long-term Treasury Bonds, these "safe" investments may lead to Capital Risk concerns as well in the current historically low interest rate environment, since interest rates and bond prices move inversely.
Avoiding capital risk exposure altogether is generally not appropriate, nor feasible, for investors with long-term time horizons and goals. However, ignoring potential Capital Risk exposures can prevent even long-term investment strategies from achieving their goals. The current low-interest-rate environment may make seemingly "safe" asset classes more susceptible to capital risk at this time.
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