## 2013-02-17

### Financial Risk (Or: You Can’t Afford Not To Invest)

Financial risk is the risk that your financial holdings will lose value with time. Everyone is very familiar with the concept of market risk: if you buy an asset, the value of the asset will fluctuate with its perceived market value. If the value decreases, you will lose money if you exchange the asset. Fear of market risk scares many people away from the subject of investment entirely.

But market risk is far from the only form of financial risk, and total financial risk is the sum of all forms. Another important type is inflation risk: if the general price level increases at a rate higher than the economic value of an asset, the real value of the asset decreases and you will lose money if you exchange the asset.

### Hidden Dangers

Market risk is scary in a very visceral way: if you purchase a stock, you can open up any web browser and see the value of that stock go up and down in realtime. Rapid swings in value can incite a fight-or-flight response and encourage irrational behaviour. This is amplified by the brain’s (and the news media’s!) tendency to overemphasize the importance of recent changes while ignoring long-term trends. When the market drops 2% in an afternoon, no one ever seems to remember the slow, steady gains of 10% over the past year. Humans have trouble parsing trends when events are happening over multiple timescales.

Inflation risk is not scary - and consequently much more dangerous - for much the same reason. While market values fluctuate over short timescales, general price levels undergo slow, steady changes over much longer periods of time. Over the last hundred years, the inflation rate as measured by the Consumer Price Index - an average of the price of a large collection of consumer goods - has been just above 3% per year:

 The average CPI and percentage annual change in average CPI over the last 100 years

If prices rise on average 3% per year, your $20 bill will only have$10 of today’s value in 23.4 years. That’s right: at modern inflation rates, prices double roughly every 20 years(*).

The insidious thing about inflation risk is that, though it will erodes the value of your financial holdings just as readily as market risk, it can do so while the list value of the asset remains unchanged. In twenty years, that \$20 bill will still be worth twenty US dollars... but its real value will have decreased.

And this is why ‘safe assets’ - like cold hard cash under the mattress, or a savings account earning 0.01% - are the most dangerous investments of all. While they have little to no market risk, the real value annual rate of return is on the order of -3%.

### The Solution?

The only way around this is to accept some level of market risk (or default risk, or currency risk, or...) in exchange for a higher potential rate of return. By investing in the debt and equity of companies, governments, and other institutions in the form of bonds, stocks, and related financial instruments, it is possible to beat inflation and grow the real value of your money.

But what to invest in and how to invest it? If you’re a student or an early-career professional in the United States, the place to start is probably a Roth Individual Retirement Account (‘Roth IRA’). Start with a detailed Roth IRA action plan.

(*) The relationship between inflation and the CPI is actually a lot more complicated. See:
http://en.wikipedia.org/wiki/Inflation
http://en.wikipedia.org/wiki/Monetary_inflation
http://en.wikipedia.org/wiki/Expansionary_monetary_policy
(Then, get an economics degree and tell me how it actually works.)