Risky Business

 Risk is the potential for bad stuff to happen. It doesn’t matter what we’re talking about, it’s the thing you don’t want to happen, happening. In the investment world it’s the fear of losing money or outliving it., Problem is, if you’re not satisfied with the risk-free rate of return (in Canada it’s the yield from the 5-year Government of Canada bond), you have to add a measure of risk to get better returns. This is especially important than when inflation and the cost of living start to creep up. When your rate of return is lower than the rate of inflation (2.8% in Canada as of this writing), your purchasing power is falling.

 So how do you protect yourself and still make enough to stay ahead of inflation and pay the bills? You stop thinking about the investments your friends are telling you are sure things and start looking for ways to manage the risk. Let’s say you want to take a trip on a boat - you can’t wait for the perfect day, you’ll never leave! What you need to do is get as many things as possible, working in your favour to protect you from the unexpected. If it doesn’t happen, you still get where you’re going. You check weather reports, try to pick a time when the forecast is good. You make sure your boat’s been serviced, the mechanical is all working, batteries are charged and your gas tanks full.

 In our minds, we mostly believe nothing bad will ever happen and all our preparation will be for nothing. Truly, that is the best outcome. Sometimes though, things go differently than planned.

 Building a portfolio isn’t that different, except that the negative event(s) will definitely happen, it’s just a matter of when. You don’t hope you’ve found the perfect investment, because I can assure you haven’t. Everything has a level of risk, even risk-free investments. GIC’s may be guaranteed but that doesn’t mean they can’t fall in value, they’re also illiquid which is another form of risk. Stocks, bonds, options, futures, mutual funds, etfs, crypto currencies - they all come with different levels of risk. Markets will correct, interest rates will rise, economies will suffer in recessions, countries will go to war and bad politicians will create havoc.

 The goal should always be to build a portfolio of securities that will grow when things are good and protect you when things are bad. The biggest risk for many investors isn’t that their portfolio will fall (it will at some point), it’s when it drops relative to when they need the money. The fancy term for that is sequence of returns. If your investments fall in value closer to when you start to draw from them, than the end, you are drawing from a smaller pool of investments so you will go through your money faster with less chance of earning it back.

 So what do we do?

 1.    First step is accepting you can’t avoid risk. It doesn’t matter what you invest in, cash to commodities there is always an element of risk.

2.    Second step, understand what your needs are, what you’re comfortable with, and how long you can afford to ride it out should things go sideways.

3.    Next, we look for securities that work together, not only to earn a reasonable rate of return, but also to behave differently from each other when markets go up and down. In portfolio building, it’s the sum of the parts, not the individual holdings that creates long-term performance. As much as long-term performance doesn’t predict future returns, it does give you an indication of what has happened in the past under similar challenging conditions.

4.    Fourth, have faith in your portfolio, short-term fluctuations mean very little, and a market can behave completely contrary to our expectations for a long time. Hold unless the story changes.

5.    Lastly, review your decisions regularly. Don’t replace securities just to get something that looks better in the moment, time is your friend. You’re not looking for one-hit-wonders, you’re looking for consistent, long-term behavior and performance.

 Successfully managing risk is about a series of small steps, not a couple of lucky guesses or one good pick. You don’t wear your life jacket because you think the boat will sink, you wear it because it might. It’s not about avoiding risk, it’s about protecting yourself as much as possible from the impacts of it.