But don't try to avoid them all, either.
Sometimes bullet points can cause trouble.
For every fund that we review on Morningstar.com, we also provide a few bullet points, meant as quick summaries of the fund's main pros and cons, which we call "Kudos" and "Risks." (The latter used to be labeled "Concerns," but maybe that sounded a bit too touchy-feely, as in, "I'm afraid your fund has some issues ...") These being bullet points, they do not provide complete explanations, just quick hits.
As a result, I once received a message from a reader who was puzzled--to be diplomatic--about my bullet-point comments for two Vanguard foreign funds. For Vanguard Total International Stock Index
With more than a hint of sarcasm, the reader wrote something along the lines of, "So, one fund is risky because it owns emerging markets, and the other one's risky for doing the exact opposite?" The implication: Either there was a typo somewhere, or the two statements made no sense.
I understood where he was coming from. It does sound strange. But, as I explained in my response, I did mean what I had written. The reasons why are worth going into in more detail. After all, whenever the markets climb these days, many commentators immediately label it a "risk rally," with investors ostensibly "regaining their appetite for risk." Whether or not that's true, what's problematic is that such a description reinforces the idea that the riskiest securities are easy to identify: Russian companies whose leaders could be thrown in jail at any moment, biotech firms with their entire future riding on one breakthrough drug, and the like.
Yes, such things are risky. And I confess to using the term in just that way at times. But it's important to recognize that the threat of a company quickly losing most or all of its value--which is basically what we're talking about above--is just one type of risk. Investors must also consider other risks, such as long-term underperformance, overpaying for indexlike results, or simply losing ground to inflation. In truth, there is risk everywhere.
For the two Vanguard funds, the emerging-markets stake is the more conventional risk. Emerging markets have more political and currency uncertainties, in general, and their shares are less heavily traded, so there are added worries in owning them. But when your goal is long-term capital appreciation, there is also a risk in choosing an international fund with absolutely no companies based in the fastest-growing economies in the world--areas that house some of the world's leading firms in a number of sectors. Excluding all of them carries the risk--not the certainty, but the risk--that over the long term, your fund, and perhaps your overall portfolio, will meaningfully underperform those peers with a broader reach.
Neither Vanguard fund, therefore, is automatically riskier in the broad sense than the other. The key is to identify the two sides of that same risk. With that knowledge, investors can decide for themselves which one they prefer and won't be under the illusion that avoiding all emerging markets is a risk-free choice.
The same goes for other securities, including those normally considered conservative or even "safe" choices. Many investors consider U.S. Treasury bonds to be risk-free. But if you buy them when long-term yields are very low, you can suffer a substantial loss in a Treasury fund when rates go back to more-typical historical levels. In 2009, when the yield on the 10-year Treasury fell below 3%, some smart managers were saying that buying them at that point was about the riskiest thing that you could do. And just a few weeks ago, on May 25, the 10-year Treasury yield hit its lowest point of the year to date, 3.18%, as investors bid up Treasuries amid market jitters over Europe and the pace of the economic recovery.
Even investing in FDIC-insured CDs carries risk. If the interest rates on the CDs are very low, there's the risk--an important one--that your investment returns won't even keep up with inflation.
The idea here is not to scare you away from all investing. Just the opposite, in fact. Once you recognize that every investment includes some type of risk, you might be more willing to buy a smattering of items typically considered more chancy from time to time, if their prices are cheap and the rest of your portfolio provides sufficient ballast to offset them. Sure, they're "risky." But so is everything else that you own.
In short, the key is not to try to avoid risk. That's impossible. The true goal, even for a conservative investor, should be to understand all the risks out there and try to balance them in a way so that, one hopes, your finances will be in reasonably solid shape both in the short term and over the long run, no matter what happens.
Hmm. Maybe we should go back to simply calling them "concerns," after all.
A version of this article originally ran on Oct. 1, 2009.
Gregg Wolper is a senior analyst with Morningstar.
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