What is risk? Put simply, risk is a measure of how much an investment’s actual return differs from its expected return. It goes without saying that if you lose money on an investment, or just earn less than expected, it can have a negative impact on your finances and your life plans. When you choose to invest, you are also choosing to accept any negative outcomes that may arise as a result. Therefore the more you understand about risk the better you’ll be at making investment decisions that are right for you. 

Types of Risk

We talk about risk in the investing world a lot. If you’ve ever worked with a financial advisor you’ve probably filled out an investment risk questionnaire to help determine what type of portfolio is right for you. Something you might not know is that when it comes to investing, not all risk is the same or equal. In fact there are many different kinds of risk that, depending on where you invest, will have varying degrees of impact on your performance outcomes. This isn’t an exhaustive list but here are some of the main ones: 

Market Risk – the risk that your investments may decrease in value due to economic conditions or events that affect the market as a whole (also known as systematic risk). 

Business Risk – the risk that a particular business may not be profitable or survive, even though economic conditions are favourable (also known as unsystematic risk). Business risks can include low sales, change in demand, increase in competition, inability to cover operational expenses, governance issues, and scandal.

Concentration Risk –essentially an overexposure to business risk, concentration risk refers to the increased risk of loss on an investment when your money is overly concentrated in one business or one type of investment

Interest Rate Risk – the risk that an investment will lose value due to changing interest rates.  

Inflation Risk – the risk of loss to your purchasing power if the growth of your investment does not keep up with inflation 

Liquidity Risk – liquidity describes how easily an investment can be converted into cash. Liquidity risk is the risk of not being able to sell your investment when you want, at the price you want. Real estate investments carry high liquidity risk as market conditions determine how quickly a property can be sold and at what price. 

Credit Risk – also known as default risk, if your investment is in the form of a loan (for example corporate or government bonds or a private loan), it is the risk that the borrower will not be able to repay that loan. 

Again there are several missing from this list but hopefully you get the idea that there are a lot of external factors at play that can impact the performance of your investment. 

Here are a few examples of how different risk factors impact different types of investments:  

• Investing in a mutual fund or index ETF exposes you to market risk but reduces your business/concentration risks by providing diversification

• Investing in a GIC shelters you from market risk, but exposes you to inflation risk as GICs tend to underperform inflation over time. When it’s time to renew your GIC you will also be exposed to interest rate risk as a decline in the overnight rate will cause GIC rates to drop also

• Buying a rental property might limit your exposure to risks associated with the stock market, but will increase your concentration risk, interest rate risk, liquidity, and default risks

The Relationship Between Risk and Returns

If you’re trying to gage how risky an investment is look no further than its returns potential. Why? Because they’re directly correlated. Think of it this way: a one-year GIC which is all but guaranteed, pays a return of 3%. Would you invest in say, crypto, a highly speculative, high risk asset class, if you knew the most you might earn is 3%? No you wouldn’t because there’s no incentive for you to take the added risk over the GIC, so you might as well stick with the guaranteed option. High risk investments need to offer thepotentialto generate higher returns in order to motivate people to invest with them. Generally speaking, the higher the potential rate of return, the higher probability that your investment will not reach this potential and could possibly even lose money. It’s up to the individual investor to decide whether or not the potential to make more money is worth the added risk. 

In the investment management world we try to determine by assessing what are known as “Risk-Adjusted Returns”, which is essentially a measure of investment performance that takes into account the amount of risk undertaken to achieve a specific return. I won’t go deeper into these calculations today because it would require us to get really technical. Just know that risk isn’t always an abstract concept and it can, in fact, be measured. Oh and if you’re disappointed that we’re stopping here, stay tuned for next month’s series on how to choose investments because we will for sure revisit this concept in more depth. 

The Power of Diversification

Risk can’t be avoided but it can be managed. The best way you as an investor can mitigate your own exposure to investment risk is through diversification. Put simply, diversification means spreading your money out between a large number of investments in order to limit your exposure to any single asset or type of risk. This allows your portfolio to benefit under various economic stages and conditions. 

How much is enough diversification though? If you open a self-directed TFSA and you purchase 5 stocks – a couple tech stocks, a bank stock, an energy stock and an airline – are you diversified? To a degree, yes, but not adequately. Look at it this way: if 20% of your money is invested in one company and it fails, how much will your investment suffer as a result? A lot. If 1% of your money is invested in that company and it fails, it’s arguable whether you would even notice that failure take place. This is what makes buying funds (either active like mutual or passive like ETFs) so appealing. They give you the option to invest in a wide variety of assets even if you have limited capital to invest. 

I should add that diversifying your portfolio doesn’t mean avoiding high risk investments altogether. Who doesn’t want to benefit from the latest trend that everyone else seems to be making bank on? It just means you should try to limit the amount of capital you allocate to these types of investments to an amount that, if lost, can easily be recovered.  

Managing Your Own Risk

Is this all starting to sound a bit complicated? Honestly the world of risk measurement and management is complicated, but that doesn’t mean your investment decisions have to be. Here are some general principles I encourage my clients to follow to reduce their exposure to risk. Keep in mind these are general guidelines and are just meant to be used as a starting point. If you are new to investing, own a business, or have reached a level of personal wealth where you can afford to take more risk, your own portfolio makeup could look much different. 

• Keep 3 to 6 months survival expenses in cash in a savings account. This will help keep you liquid in the event you’re not able to tap into your investments on demand. 

• While there’s no perfect amount of stocks to hold in a portfolio, my personal take is that to achieve adequate diversification you should hold at least 100 if not more, across various sectors, asset classes, and countries. The easiest way to achieve this is by investing in funds (either mutual, segregated or exchange traded). This is your core investment portfolio and should account for at least 60% of your overall holdings. Exactly how this portfolio takes shape will depend on your personal needs, goals and tolerance for investment risk. 

• Speculative investments like crypto or AI are fine, as long as you go in with a realistic mindset and accept the fact that the best case scenario is not the most likely to play out. For this reason I usually try and limit my clients’ exposure to about 5% of their overall portfolio. This way if it does crash and burn my clients will be able to bounce back easily. 

• Owning an investment property can be a valuable addition to a portfolio as well, as long as you recognize all the types of investment risk you are exposing yourself to – particularly liquidity risk, but also interest rate risk, market risk, concentration risk, and default risk if you have tenants. Try to limit your capital investment to about 20% of your overall investments which should help you to stay liquid and avoid taking on debt or being forced into a fire sale. In the case of rental properties it is also wise to keep at least 6 months to a year’s worth of mortgage payments on hand in a separate savings account to cover things like repairs and maintenance, sudden vacancy or tenant default, or to help cover mortgage payments during periods of high interest rates. 

To summarize – when it comes to investing, risk can’t be avoided but it can be managed by following some basic principles of diversification. Whether you’re looking for active management or you’d prefer to manage your own investments, it never hurts to have a professional look over your portfolio to ensure your investment choices align with your personal needs and goals.

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