Determine your risk comfort level
Understanding two key characteristics of every investment — the risk and potential return — is vital to successful wealth building. When we talk about investment risk, this refers to how often and by how much an investment will change in price -– its variability. To most investors, risk can also mean the possibility of losing some or all of the money in an investment.
A return on investment is the amount that can be earned (or lost) when an investment is sold. The risk an investor takes is as much a personal decision as it is a financial one. Some people can accept the risk of a sudden plunge in the value of their investments. Others will balk at any hint of loss. But most people fall somewhere in between these two extremes. The amount of risk an investor can live with based on the expected return of an investment is called his or her risk comfort level.
Not many people are comfortable with the idea of risk, even though we all deal with it on a daily basis. There are health and safety risks, relationship risks, and so on. Whether or not we choose to take them usually depends on the ‘rewards’ we can expect in return. The same can be said about investing. The risk you takwhen you invest usually relates to the return made. Almost invariably, a higher risk will equate to a higher return. A lower risk generally means a lower return.
Here, in descending order, are the risk factor of various investments (eg — Options pose highest risk; Treasury bills the lowest):
- Options, warrants, futures and derivatives
- Common shares
- Preferred shares
- Corporate debentures
- Mortgage backed securities
- Provincial bonds and strip bonds
- Government of Canada bonds
- Canada and provincial savings bonds
- Treasury bills
Many factors can affect the level of risk of an investment: Business risk deals with the chance a company may run into financial difficulty; liquidity risk can mean being unable to cash in your investment when you want; and interest rate risk results when changes in interest rates affect the value of your investments.
One of the simplest and smartest ways to reduce your investment risks, without sacrificing much of your return, is by diversifying. Diversification means putting your money into a broad variety of different investments — in effect, you’re not putting all your eggs in one basket. Instead of putting all your investment dollars into stocks, for example, you could include common and preferred shares, bonds and so on. Usually, when one investment is doing badly, the others are stable or doing well. This is because financial markets do not always move in tandem.
Risk should not be thought of as negative, however. It simply means that if you want a higher rate of return on an investment, you’ll have to accept the risks that go along with it. And remember, return is as much a factor in your investment decision as risk. As an investor, you’ll determine the rate of return you’d like to receive, based on your financial objectives, and match that with the appropriate investments. You must then decide if you’re comfortable with the risk that investment carries.
Always remember that short-term deposits are not what they used to be and, again, in today’s low interest rate environment, you must protect yourself against inflation and increases in the cost of living. Growth over time is the best answer.