The Changing Face of Risk

Gordon Pape | October 28th, 2013

An investment that seemed perfectly safe a few years ago may look a lot different now. Risk is a shape-shifter and you need to know when to take appropriate action.

Most income investors worry about risk. At the stage in life where the main interest is cash flow, they don’t want to face the prospect of losing money. As a result, they tend to favour lower-risk securities.

Here’s the problem. Risk is a moving target – a shape-shifter, if you like. Securities that appear to be low risk under one set of economic conditions become much higher risk when circumstances change.

That is what we have seen over the past few months. Securities that were thought of as being defensive have suddenly dropped in value, shocking conservative investors and leaving them wondering what happened to their carefully crafted portfolios.

The casualties of the rising interest rate environment read like a catalogue of low-risk securities: bonds, preferred shares, REITs, utilities, telecoms and some other dividend-paying blue-chip stocks, to name a few. As a result, investment strategies built around these securities have been hammered.

In one of last week’s columns, I updated my model RRSP Portfolio. Every single defensive security was down since the previous review in February, some by more than 10 per cent. Only the three growth-oriented mutual funds in the portfolio enabled it to show a small gain over the period.

In effect, the investing world has been turned on its head. Growth stocks, normally considered to be far more risky than bonds, now must be considered as key components of a portfolio if the goal is to preserve capital.

Many investors will find it difficult to adjust to this new reality. They’ve done very well with a defensive portfolio in recent years and overhauling it is difficult. But times change and we need to change with them. This means reviewing your portfolio carefully and making sure you include some growth securities in the mix.

This does not mean you should dump all your defensive holdings. As always, balance is the key. The current assumption is that interest rates will continue to move higher. But that is predicated on forecasts of an improving economy. If growth stalls or starts to slip, interest rates may soften again and those government bonds, REITs, and preferred shares will look pretty good.

Because of the rapidly changing environment, I am continuously adjusting the risk ratings in my newsletters in accordance with the current conditions. This means that a security that was originally rated as “conservative”, such as a universe bond ETF, may be reclassified as “moderate risk” or even “higher risk.” Be guided accordingly.

In volatile times such as these, we have to be ready to adapt quickly to changing circumstances. That does not mean you should depart from your basic objectives. It does mean, however, that you need to be flexible on the best ways to achieve them.

This article originally appeared in Gordon Pape’s Income Investor newsletter. For details on how to subscribe go to http://www.buildingwealth.ca/bookstore/productdetail.cfm?product_id=533