Why Risk is a Good Four-Letter Word

Risk is one of the most misunderstood words in investing.

Consider the different interpretations. Large financial institutions define risk as volatility. They worry about short-term ups and downs in the stock market and have designed their risk management systems accordingly. Some investment managers believe risk is the amount their returns deviate from the index. Too much dispersion, or tracking error, is bad. Indeed, it can be career-ending if the gap is to the downside. Individual investors too are shaken by market volatility, but their biggest worry is permanent loss of capital.

Before addressing what risk is to you, let’s eliminate a couple of possibilities.

Things that Shouldn’t be Seen as ‘Risks’

First off, high tracking error is not a risk. This one strictly belongs to investment professionals, who are rewarded for how they do relative to an index. Beating the benchmark without significantly deviating from it is their holy grail, although it means little to you. Positive absolute returns build wealth, not relative returns. Personally, I shy away from Canadian equity managers who target a low tracking error. Our market is skewed to a handful of industries, so
hugging the index leads to an undiversified portfolio.

For investors who are properly diversified, loss of capital is also not a risk. A few poor stock picks aren’t going to devastate returns. Neither are declining oil prices or debt issues in Greece. I say this knowing that many Canadian investors get carried away with what’s popular at the time. Portfolios were dominated by foreign stocks in the early 2000s (do you remember Clone Funds?) and were all-Canada 10 years later. Along the way, there’s been oversized holdings in technology, oil and gas, precious metals, banks and since 2008, cash.

There’s a reason why diversification is called the only free lunch in investing. If you have broad exposure across industries, geographies and asset categories, the ride will be smoother without sacrificing returns. Negative events will impact your portfolio in the short-term, but a full recovery is all but assured.

Risk is Personal

If tracking error and capital losses aren’t risks, what about volatility? On this one I can’t be as unequivocal. The answer depends on your stage in life. A decade ago, I stepped away from the business for a short time and learned what it’s like to be retired. A friend told me at the time, “Living off your wealth is very different than building your wealth. It’s a whole new ball game.” He was so right. Retired investors must think long term, but also need to account for regular withdrawals. This brings volatility into the equation.

Down markets always go back up, but when the weakness is prolonged, withdrawals chew into the capital needed for full recovery. Retirees must manage their cash flow with volatility in mind. For investors who won’t touch their money for at least 10 years, short-term market gyrations are not a risk. Indeed, they’re a blessing. Volatility creates opportunities to buy at reduced prices. This requires, of course, that investors stay on plan through market tops and bottoms, both of which are breeding grounds for return-crushing mistakes.

It might surprise you, but I believe the biggest risk for accumulators is not taking enough risk. By this I mean having too conservative an asset mix and/ or not having every available dollar invested to benefit from the power of compounding. It seems perverse, but holding secure, savings vehicles is a high risk strategy. It doesn’t in any way match the time frame (long term) or goals ( building wealth and slaying inflation).

Your Future with Risk

Risk has four letters, but it’s not a dirty word. When combined with time, it’s the fuel that drives your portfolio. Without it, you’re destined to achieve returns accorded “risk-free” assets like GICs and government bonds.

But risk is a personal thing. It may be different from what others are worried about. To build a portfolio that fits your needs for growth and income, you need to allocate across all four types — interest-rate risk (bonds); default or credit risk (corporate bonds); equity risk (stocks); and liquidity risk (private investments). Your risk management system is getting the mix right, and resisting the temptation to deviate from it for short term, emotional reasons.

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