Protecting against the right risks

Mon, 26 Feb 2024 12:07:55 PST

Interest rate hope

This article was first published in the Globe and Mail on February 24, 2024. It is being republished with permission.

by Tom Bradley

Risk is a loaded word. It has negative connotations for most people, and is something to be avoided.

Unfortunately, it’s an essential part of investing. It’s embedded in the math – risk plus time equals return. If you want returns in excess of the risk-free rate, which for most investors is a government bond or GIC, you need to take risk.

I want to explore three important aspects of risk, but I’ll start by defining the four types of investment risk.

When you seek a higher yield by buying a bond with a longer term to maturity, you’re taking interest-rate risk. The longer the term, the more sensitive it is to changes in interest rates. A long-term bond with a fixed yield becomes less valuable when rates go up, and vice versa. This risk was obscured for 40 years by steadily declining yields, but it reared its ugly head in 2022.

To gain more yield, investors can also take credit risk, which means accepting a higher chance of default – owning a corporate bond instead of a more secure government bond, perhaps.

Number three is the biggest risk in most portfolios – equity or ownership risk. If you hold a stock (or fund that holds stocks), you’re a partial owner of a company, which may deliver dividends and growth, but may also result in a loss if things don’t work out.

And number four is liquidity risk, which involves accepting limited liquidity in exchange for a higher potential return. For example, investors should expect a higher yield on a mortgage fund that only allows redemptions once a year.

All these risks contribute to returns in different ways at different times, and each can be dialled up or down.

Of course, you never know all the risks at work in your portfolio. Carl Richards, author of The Behavior Gap, said it well, “Risk is what’s left over after you think you’ve thought of everything.”

Now, let’s drill into how you interact with risk.

It’s different for everyone

Risk is personal. It’s your very own, based on your financial situation, personality, and goals for the money.

The media tends to assume that everyone has the same risk profile, but volatility isn’t bad for everyone, nor is a weak stock market. For money set aside for a short-term purpose, such as a trip or kitchen renovation, a down market is a risk that needs to be protected against. For money being invested for retirement decades in the future, a dip is a blessing. It’s an opportunity to make contributions when stocks are on sale and potential returns are better.

Paying for protection you don’t need

The wealth management industry is very creative. Overwhelmingly, structured products are designed to reduce volatility. The focus is not on maximizing return but rather attaining a reasonable return with smaller declines. That’s the holy grail for index-linked notes sold in bank branches and liquid alt funds deploying hedge fund strategies (Note: higher fees, including profit sharing, also moderate returns).

These products can be good diversifiers because their returns tend to follow a different pattern than bonds and stocks, but for portfolios with a multidecade time frame, where zigs and zags are unimportant, they make less sense. These investors want to fully benefit from the compounding effect of owning good companies for a long period of time. Sacrificing returns to reduce a risk they don’t care about is a bad tradeoff.

Divide and conquer

Most investors have more than one goal. Young families are investing for retirement and setting money aside for short or medium-term needs like down payments or kids’ education. They have multiple pots with different risks, each requiring a different approach.

A retired investor needs a steady income in the next one to five years but also must invest money that can grow and provide an income in 15 to 25 years.

Whether you’re young, old, or in between, risk is something to be managed, not avoided.

That means dividing your portfolio into separate pots, based on time horizon and return objective, and then deciding what risks you need to guard against in each.

It means building a portfolio that’s diversified across a variety of risks so you can reap the rewards without letting one misfortune take you off course.

And when consuming investment information, or getting a tip from a friend, determining if it’s appropriate for any of your pots. Are you playing the same game as a buddy who’s looking for moon shots, or conversely, your grandfather’s conservative dividend stocks?

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