3) VALUATION RISK or "Market Risk." Separate from the health of individual issuers of securities, there are seasons and cycles in the markets themselves that influence the valuation of securities. A business may be doing "just fine, thank you," yet for months or even years the price of its stock could fall due to market factors unrelated to its business. Market valuations of both stocks and of bonds tend to run in long cycles, presenting, alternately, risk and opportunity for investors.

4) MACRO-ECONOMIC RISK. Economic activity in free markets tends to expand gradually over time due to population growth and rising workforce productivity that comes from innovation. In general, economic growth is a long-term positive for stock prices... but growth is cyclical and surprisingly erratic. Even a temporary contraction in spending by consumers, businesses or governments can depress corporate profits and stifle investor enthusiasm for stocks. A rising or falling trend in interest rates also has a strong influence on both bond and stock prices, as do demographic changes, savings rates, shifts in competitiveness among nations, and the direction of regulations and other government policies.

5) SYSTEMIC RISK. The development of paper currencies and fractional-reserve banking, and the evolution of liquid public markets in all sorts of securities have made possible the integrated global economy we now take for granted. A rupture to this complex and somewhat fragile financial system, say from liquidity or solvency crises, electronic terrorism, social upheavals or wars, could provoke wide-ranging economic turmoil. We believe risk to the system is not trivial. More later.

Investment Risk Is Unavoidable For Most Of Us
The risk management profession teaches that there are four basic strategies for handling risks once they are identified: avoiding them, transferring them to another (insurance), minimizing the potential consequences, and accepting the risk while budgeting for the consequences.

Those of us who expect to cover our retirement expenses from our life's savings really don't have the first option, avoidance, because not only does all investing include some element of risk, even not investing includes the on-going risk of currency debasement (Inflation).

At age 65, Bill and Marylou Daily's situation is typical of upper middle class retirees. Their comfortable home is paid for. They can't qualify for long-term care insurance, so nursing care is a meaningful unknown. Their adult children have very little savings, so they'd really like to give them a boost in life with some inheritance. In today's dollars, Bill and Marylou project that for living expenses and income taxes they'll need $50,000 a year above what they'll receive from Social Security. They have just retired with $1.5 million of investment assets.

If we assume future inflation of 3.4% (the long-term U.S. average) it seems these people will need a nominal investment return averaging about 7% a year to achieve their goals. Currently, ten-year U.S. Treasury bonds pay just 1.5%, and one-year bank CDs offer barely 1.0%. Clearly, Bill and Marylou's portfolio strategy needs to include some investment risk if they are going to have any chance of realizing their goals.

Let's examine the five kinds of investment risk, one by one, and outline our FAI strategies for managing each one in an investment portfolio.

INFLATION RISK
For those of us who live and work in the United States, the value of everything is denominated in U.S. dollars. Some examples: An executive may earn $150,000 a year. Her portfolio is worth $1,700,000. A certain house just sold for $660,000; its property tax is $8,500 a year. A new Honda Pilot costs $42,000. One family's living expenses are about $120,000 a year.

The thing is, if we made this same list 10 years ago or 10 years from now, most of the numbers would be significantly different. We might expect the dollar cost of some things to decline because we live in a free market economy where innovation brings efficiencies to our manufacturing and distribution processes. But a relentless upward pressure on prices is government's purposeful increase in the amount of dollars in circulation relative to the level of economic activity in the country.