July 09, 2020
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By taking the time to understand the full scope of the potential risks and rewards of an investment, you can save money, potentially make money, and possibly avoid some of the disappointment and surprise that can happen when things don’t go as planned.
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Risk is a fact of life. We encounter it every day—even during life’s most mundane activities. Some risks are minor and barely register on our radar, but the risk that things won’t go as planned is always present. For instance, every time you drive toward to a yellow light, you are faced with a choice: prepare to stop or attempt to cross before the light turns red. The latter could result in a fine, or worse, motor vehicle accident—neither of which are worth risking to shave a few minutes off of your commute.
In the world of investments, risk generally relates to uncertainty. It refers to the possibility that an investment could be lost entirely, or that an investment will yield less than its expected return. Simply put, risk is the chance that an investment will perform differently than anticipated. Also, just like in the real world, risk isn’t necessarily negative. Where some see risk, others see opportunity.
The primary goal of investing is to make money on your investment. But there is a trade-off—you can’t generate a return without taking on risk.
Volatile investments entail unpredictable potential returns; therefore, they are riskier. Generally, the greater your desired return, the more uncertain the outcome and the greater the risk you’ll have to accept to achieve your goal. Conversely, if you want a more predictable outcome with less risk, you’ll likely have to accept a lower potential return.
Time also factors into the size of your potential returns and the amount of risk exposure that you’ll need to achieve your goals. The length of time that you have to invest is known as your “investment time horizon.” Typically, if you have a longer time horizon, you can afford to be more aggressive and invest in higher-risk investments. With more time, you’ll be able ride out market fluctuations and have more opportunities to achieve a higher return.
Each of us has a different ability to withstand investment risk. This is referred to as our “risk tolerance.” Those who don’t mind taking on more risk in exchange for a higher potential return are considered “risk tolerant.” Conversely, those who prefer safer, more predictable outcomes and don’t want to take on a lot of risk are known as “risk averse.” Determining your risk tolerance is not an all-or-nothing proposition—most people fall somewhere between the two extremes of the risk tolerance spectrum.
In determining which investments best match your risk-return expectations, your risk tolerance is as important as the risk of the investment itself. If you are more risk averse than you initially thought, it could be difficult to sustain an investment strategy during difficult periods. The potential rewards may just not be worth the stress and worry caused to you. Also, it is important to remember that your risk tolerance will likely change over time depending on your evolving needs and goals.
With investing, just like in daily life, there are different types of risk. Each investment is subject to general uncertainties associated with that type of investment, also known as “systematic risks.” These include market, interest rate and purchasing power risk, among others. Risks that are particular to a company, industry or class of investments are known as “unsystematic” risks, because they can be addressed (at least in part) by investing in more than just that one company, industry or class. Unsystematic risks include business, financial and default risk, among others.
There are multiple ways to evaluate risk, many of which involve the use mathematical tools and techniques (e.g., standard deviation, beta, alpha and so forth). By using standardized risk measures, investors can make educated decisions about the suitability of an investment.
Diversification is one of the most powerful and common tools that can help an investor manage and reduce risk. Because varying types of assets will behave differently depending on market conditions, a diversified portfolio that includes investments spread across a range of asset classes (e.g., cash, bonds, domestic and foreign stocks, and real estate) can broaden your investment base and lower your risk exposure to any single asset type.
Ideally, in a diversified portfolio, some investments will increase in value while others will decrease in value. The increases will help offset the decreases and minimize the impact of loss from a single type of investment. The goal of diversification is to find the appropriate balance of different investments for your portfolio based on your investing goals, risk tolerance and time horizon—a process called “asset allocation.”
Diversification can be achieved by company, industry, type of security, markets or by investment objective. How an investor chooses to diversify will depend upon his or her own situation.
Ultimately, it is a lot easier to effectively manage risk than investment performance. While you can’t predict the direction of the financial markets, you can manage risk and possibly even benefit from it with proper asset allocation and portfolio diversification.
CIBC Private Wealth’s Wealth Your Way podcast series—an educational offering for clients and their children—demonstrates our commitment to developing the rising generation.
July 07, 2020
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