By Mike Onotsky
In my years dealing with hundreds, if not thousands, of clients, probably one of the most common questions I am asked is “how much risk should I take?” This is usually followed by “how much risk should I take?” to which I answer “Irrelevant.”
We each take different risks, for different reasons, at different times. My role as a financial planner is to help you determine the right amount of risk. I have 28 year old clients who will always be in GICs and 90 year olds who will always be in equity mutual funds. No two investors are the same, therefore, no two portfolios are necessarily the same.
People often only think about risk as it relates to stocks, but there are others to consider. Here are some different risks to be aware of when looking at your investment portfolio strategy.
Stock Market Risk
One of the bigger investor concerns is, of course, the stock market ups and downs. When you hold any type of investment that’s based on the stock market, aside from a money market fund, bond fund, and some specialty funds, you have at least some exposure to the stock markets. When you hear “equities”, think “stocks”.
Risk, when it comes to equity funds, is mostly known as Market Risk. This simply means that if you have exposure to equities (stocks), you are at risk of your portfolio dropping in value if the stock markets drop in value. I won’t get into how a fund manager reduces market risk here, but let’s just say what you may already know based on your own portfolio; If you hold stock or equity included funds, you are subject to drops in value based on how the stock markets/individual stocks perform.
Interest Rate Risk
What people often misunderstand is that bonds also have their share of inherent risk. Bonds and bond funds are subject to Interest Rate Risk. Basically, as interest rates in the marketplace increase, bond values decrease. This is why you may have heard that when rates begin to rise again, fixed income funds (of which bond funds are a part of) and most bonds, will tend to drop in value.
Why? Think of it this way:
- On January 1 you buy a single, 1 year till maturity, bond in company XYZ for $100 and it pays 5% interest annually. It would be said to have a yield of 5%. It will pay you $5 for a $100 investment at the end of the year.
- On July 1 interest rates rise and someone else can now buy that same $100 bond in company XYZ but it now pays 6% in interest annually. This new bond would have a yield of 6%. It will pay you $6 for a $100 investment at the end of the year.
- Why would anyone want to buy your bond for $100 if they can spend the same amount and get a higher yield elsewhere?
- The reality then is that you need to offer your bond at a lower price to match the yield on the new bond if anybody wants to buy it. The price you will ask would factor in not only your interest rate but also the time left until it matures. Suffice it to say that you will have to sell the bond for less to match current yields (how much you make for how much you invested…if you invest less, ie. buy the discounted bond, you know you’ll make less interest).
So, bottom line, when interest rates go up, bonds go down (generally). Fund managers have ways of reducing interest rate risk buy holding bonds of varying duration, mix of government and corporate bonds, etc. In the end though, there is still a risk when interest rates increase.
In a low rate environment there can also be Inflation Risk. Think about current GIC rates. They barely, if at all, match current inflation rates so, in effect, the returns being generated are not even helping you keep up with the rate at which your living costs are increasing. Forget about the fact that if these are held outside of a registered account that you are losing even more to income tax.
If someone buys single stocks, there are subject to Business Risk. That is the effects of one company doing poorly and their stock dropping in value.
There is Liquidity Risk, the risk that you may be purchasing something that can only be cashed in a certain times such as GICs, some real estate based funds, etc. The market they are playing in may drop in value as a whole before you can get out due to redemption schedules.
Exchange Rate Risk
When you buy foreign investments in their currency, you are subject to Exchange Rate Risk. This is the risk that the Canadian dollar will increase in value over their currency, thereby reducing your return on the fund/investment.
What Should You Do With All This Risk?
In the end, there is a lot more to consider when building a portfolio that is right for you. You need to start by considering your overall risk level and then finding products that blend together to match that risk level. If you have some higher risk investments, maybe you want some lower risk ones to offset and provide balance in your portfolio.
In the end, your financial advisor should be sitting with you a minimum of twice a year to review your holdings, and revisiting your risk appetite and profile at least once a year to ensure that you are still invested in the right asset mix for you.
If this isn’t happening, it’s time to consider if you have the right person at the helm of your financial future.
Want to get in touch with Mike Onotsky? Visit his profile here.
Have a comment? Please leave it below.
Thanks for reading.
Back to the 2015 Winter ProvERB.