The Great Risk/Return Tradeoff

Benjamin Graham, the godfather of portfolio management and mentor to investor billionaire Warren Buffett, is quoted as saying:

“An investment operation is one which upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

One of the biggest challenges a financial advisor faces is helping the average investor understand the relationship between risk and reward. Investors are bombarded with information about investing in the next “hot” investment. We hear stories from friends and associates about the “big score” they made investing. We read about investments that assure impressive returns with limited risk. After hearing these claims, we may feel pressured to make changes to our investment strategy.

What is risk?
Investors have to realize that each change comes with a cost and that cost might be additional risk. Risk refers to the possibility that an investment could lose value or fail to gain in value due to swings in the financial markets. Although all investments are subject to risk, some risks are more obvious than thers.

Risk can also mean that you fail to achieve your financial goals. As a result, you do not have enough capital to retire in comfort when you want, send your children to college, or you have to put off buying a cottage for a few more years. This is a far more serious consequence than swings in the market.

Carrying out the right strategy is difficult because you have to maintain confidence in it and use discipline accordingly. If you are not convinced that that your approach is appropriate, you may jump between ventures seeking the holy grail of investments. Unfortunately such an investment does not exist.

The Risk/Reward Tradeoff
All investments include a risk/return tradeoff. Historically, lower-risk investments such as cash equivalents (e.g., fixed deposit) have offered less potential for long-term growth and investment return. Higher risk investments such as stocks have presented greater potential for long-term growth and investment return. By understanding the risk associated with various investment options, you can choose investments that best match your risk tolerance and personal circumstances.

Deciding how to invest
Where you place your money depends on many factors. Most people hate the thought of losing money (Risk) but at the same time want to make as much as they can on their investments (Return). So, how much risk should you take with your investments? Only you can answer this.You need to create a comfortable balance between risk and return.When establishing this balance, consider your:

• Risk tolerance — the amount of risk you are comfortable with and can afford to take. Can you still sleep at night if your investments experience short-term losses? Do you have enough savings to allow you to take some investment risk?

• Investment time horizons — the length of time your assets will be invested. Unless you are close to retirement or have a short-term investment time horizon for other reasons, you should generally invest for the long term. However you need to decide what ‘long’ signifies to you. For many investors, it can mean until the first drop in the market. If you think you may be tempted to do this, you should consider a more conservative investment structure.

• Overall financial situation — the amount of money you will need to sustain your lifestyle during retirement. Have you planned accordingly? How are all of your assets invested? What are your financial commitments?

How much risk are you willing to take?
Since investment objectives and goals differ from one person to another, the question of how much risk to take is a personal one and no one solution is appropriate for everyone. If you need help in determining your risk/reward ratio, we recommend an approach called the Por tfolio Management System. This system entails completing a questionnaire designed to assess your level of risk, your time horizons, etc. Your answers will help determine the best type of portfolio for the amount of risk you are willing to assume.

The next step in the process is to complete an Investment Policy Statement. This document outlines each risk in your recommended portfolio and how your strategy will minimize it. We will then choose appropriate professional money managers to administer each component of your portfolio, and agree on a rebalancing strategy and a methodology to review manager performance on a regular basis.

This system allows you to focus on the amount of risk you are willing to take to achieve your financial goals and provides you with a disciplined method for making future investment decisions.

This report is written by Investment Planning Counsel, a fully integrated Wealth Management Company. Mortgage services provided by IPC Save Inc. Mutual Funds available through IPC Investment Corporation and IPC Securities Corporation. Securities available through IPC Securities Corporation, a member of CIPF. Insurance products available through IPC Estate Services Inc.