Manage risk in today’s markets
With the unsettling events of the past three years, the plans of many Canadians have fallen into disarray. Stories of postponed retirement and working after retirement to make ends meet are all over the media lately. This comes as no surprise since, in many ways, the opening years of the 21st century have been more stressful than any we have experienced since the end of the Second World War.
These times have brought home the true meaning of the word “risk” when it comes to investment decisions. Today, every thinking person is carefully weighing the risk involved before committing to any type of investment.
For mature Canadians, it’s more important than ever to be conscious of risk. All our lives as investors, we’ve been told not to worry about short-term stock market gyrations because there would be plenty of time to ride them out and catch the next wave. That’s no longer the case. Short-term movements definitely matter, as those who find themselves revamping their retirement plans as a result of the three-year bear market will attest.
Different kinds of risk
Still, when it comes to risk assessment, it’s important to keep thin in perspective. First, it’s essential to understand there are different kinds of risk, some of which may not be immediately apparent, and to remember risk is a relative concept. What may be acceptable risk to one person may be totally unacceptable to another.
There are some securities that come close to being risk-free. For example, when it comes to protecting your capital, Government of Canada Treasury bills are about as safe as you’ll find. Since the federal government’s not likely to apply for creditor protection any time soon, the only investment risk you face is a sudden rise in short-term rates that could temporarily affect the market value of your T-bill – and this only matters should you have to sell in a hurry.
But T-bills have other risks that aren’t as obvious. Inflation risk is one example. Here’s how: at the time of writing, three-month bills were yielding less than three per cent annualized. But inflation was running well above that level. So, in terms of real return, investing in a T-bill guaranteed a loss from the outset. If the bills are held outside a registered plan, tax will only exacerbate the problem. While you may feel comfortable about a T-bill investment, if the real return after inflation and taxes is negative, you may want to investigate other alternatives.
Another factor to consider is that a security’s risk level can vary according to external conditions. When interest rates are high and the economy is slowing, central banks are likely to reduce rates. This makes bonds with higher interest rates more attractive and, therefore, more expensive than new issues, which will have lower yields. Conversely, when rates are extremely low and the economy is expected to rebound from a slump, bonds carry a much higher degree of risk since, if interest rates rise, investors will expect higher yields from any new bonds they buy. The demand for low-interest bonds will drop, and market prices will sag accordingly.
High-yield corporate bonds (so-called “junk bonds”) are exceptions to this general rule. They’re less sensitive to rates, and their prices tend to rise during a recovery because the risk of default is seen as lower.
Focus on the short term
I believe bonds should form a part of every portfolio over the long term – but only a part. And when the risk level is high, the smart move is to focus on short-term issues (maturities of less than five years) if you’re adding to your bond mix.
To manage risk properly, you must assess every security in terms of its risk-return relationship. Remember, the greater the potential return, the higher the risk. A security that provides a cash flow yield of 10 per cent is dead certain to be more risky than one yielding five per cent. If anyone tells you otherwise, it’s a lie, pure and simple