Risk is an issue which is probably least understood by investors, advisors, and the regulators that oversee the industry. Risk is multi-faceted. Every asset class has risk. Even cash in the bank suffers the erosion of inflation and taxes.
Risk can never be avoided, but can be managed. Appreciating and understanding risk is important to being successful.
Classically, risk is viewed as short-term variability (or volatility) of market value. This view allows for basic statistical measurement. We can calculate standard deviation and put a number on historic volatility. While we view short-term volatility as one important measure of risk, it is limited. For example, an investment can rapidly increase in value — which is okay! Our concern is downside volatility.
Part of our process is to manage volatility through diversification. Mutual funds are inherently diversified because they hold many securities. When we take a balanced approach, we further diversify among stocks (equity funds) and bonds (fixed income funds), not just one asset class.
We achieve diversification among equities by region (domestic versus global), sector (companies in various industries such as financial, resource, technology, manufacturing, etc.), and market capitalization (large versus small companies).
Bonds and other fixed income investments are diversified by duration (a measure of price sensitivity to interest rate changes), credit quality, issuer type (federal, provincial, corporate), region (domestic, foreign), and type (e.g.; mortgage bonds, convertible debentures, etc.)
Finally, we like to diversify among managers who exhibit differences in management style (e.g., growth versus value).
Statistically, the downside risk over a ten year period in the strategies we recommend is comparable to owning a house in the city of Toronto. Most people do not worry about the risk of owning a house. On the contrary, we expect to see the value of our houses to go up over the long term. Experience shows us that financial markets perform exceptionally well over time. We invest in professionally managed portfolios to mitigate risk and optimize wealth.
The following two videos discuss risk from two different perspectives – traditional investment risk and our biggest risk in retirement. Enjoy!
Investment Risk – and how it is best managed.
Our biggest risk in Retirement