Friday, 11 July 2008

Risk: What Can You Afford and What Can You Put Up With?

Risk is the chance of loss. Loss only occurs when you sell the investment, not during fluctuations in value, such as happen every day in the stock market. Unfortunately, it may be difficult to decide whether a decline is permanent or temporary - is Nortel ever going to bounce back to its former lofty heights? - and how long "temporary" might be.

Some investments, like GICs, do not change much in value, always moving ever so slowly upward. No problem there. With equities, however, there is variability, often quite a lot, even though over the long term, stocks do gain by much more than GICs.

This dilemma can lead to several undesirable outcomes. First, if you actually sell after a decline, there may be less cash than needed for an investment goal like education. Second, if you get worried, panicky or impatient, you may sell prematurely, what might be called buying high and selling low, the exact opposite of the dictum to "buy low and sell high".

These two outcomes should lead any investor to examine him or herself from two perspectives:
1) What you can afford to lose without disastrous financial effect, the rational weighing of the ability to bear risk and possibly sustain losses? Here are the factors to consider -
  • financial assets - the more you already have, the less the impact of a loss and the more you should be able to bear risk
  • present and future income - the more you earn and especially the more you have as disposable income now and looking ahead, the better chance you have of bouncing back from losses
  • time horizon or length of time before you will need the money - the longer you have, the more you can afford to wait through the fluctuations of the stock market, for instance ten years or more
  • liquidity needs - similarly, the less you might need at once, the more it is possible to look to riskier investments
2) What you can sustain psychologically in periods of downturn for investments like equities? Some factors here:
  • sleeping at night - how much of a decline does it take to ruin your peace of mind; apart from the mental anguish, a weaker stomach can lead to selling too early, so often it seems just before things begin to go back up.
  • impatience - if you get frustrated and fed up when declines last many months or even several years, investing in stocks that do periodically experience such declines will probably lead you to sell prematurely at a loss, only to miss out on the rebound
There are a number of free risk tolerance questionnaires available that anyone can use to get an idea how the above can lead to a suggested list of types of investments (typically cash, fixed income and various types of equities) and a percentage allocation to each category. Try several and compare results.
Bank of Montreal Investor Profiler - gives separate pre- and post-retirement recommendations; no registration required
IFA Canada Risk Capacity Survey - three versions: ultra-short (5 questions), long (49 questions) and RRSP (19 questions); requires registering to get the results
Edmond Financial Group Risk Tolerance Questionnaire - no registration; very quick to do
MSN Money Risk Tolerance Quiz - 20 questions; gives portfolio composition suggestions

It is significant that knowledge of investing principles increases the tolerance, in both the above senses, for risk. Setting proper expectations about likely rates of return and especially the possible multi-year down periods, gives a greater peace of mind of mind and patience to ride out variability. Knowledge also enables the construction of a portfolio of investments that has less variability and risk of loss and very good long term returns, as will be explored in future posts.

No comments: