Day 16 The varieties of risk
Continued from Day 15, below …
The Varieties of Risk
Many people have contacted me over the last three years to say that they’ve sold their equity investments wholesale, and have moved back into the safety of GICs. For some people, that is the very best option, but it is not as no-risk as we’d like to think. As you build wealth and move into retirement, you’ll face different kinds of risk, and a GIC portfolio only helps you avoid a few of them. We are here to help you minimise all risk by achieving an appropriate balance, depending on where you are in your life cycle. For the vast majority of us, the lowest-risk portfolio is not a “guaranteed” portfolio, but a diversified portfolio.
A diversified portfolio is one that shields us from all of the varieties of risk – let’s begin by reviewing them.
The risk we focused on during the late nineties was “opportunity risk” – the risk of not participating in the world’s largest, longest bull market, and losing out on the money to be made there. That risk, or fear, compelled us to buy at unreasonable prices, to invest more than we could afford, and to ignore another type of risk – market risk.
Today, we are all very familiar with market risk, or the idea that stock markets can decline and behave far differently than their long term averages would have us believe.
We know that North American markets – which represent our opportunity to participate in the profits of Canadian and US business growth – behave unpredictably. This is particularly true between market sectors, or industries, and even more so with individual companies. There are two primary antidotes to market and sector risk, time and diversification, and we’ll cover them both in detail later.
Another risk we came face-to-face with during the bear market is behavioural risk. Yes, as Pogo mused, “I have met the enemy and he is me.”
When we first bought those mutual funds or stocks, we probably completed a 4-page questionnaire designed to identify our “risk tolerance level.” On a Know-Your-Client form, we were asked to state our “sophistication level.” The implication was that the more sophisticated we were, the more risk we were able to withstand. We were shown colourful charts demonstrating that the ability to take on that risk would result in much higher long term returns. (And if that were not appealing enough, who could resist being seen as “sophisticated”?)
Somewhere in the small print, or in a throw-away comment, was something about the possibility of our investments declining, but then there was that chart, with its relentless upward march prevailing over meaningless short term volatility. Only an unsophisticated rube would let a little short term volatility keep them from the promised riches, right?
I know. I was there. I was one of the many advisors whose careers had begun after the long bear market of the 70’s – one of the many advisors educated by the financial industry to help people increase their risk tolerance, make more money, and enrich the financial industry (and me) while doing so. But during the process, I began to learn from experience, and from the behaviour of my clients.
For example, I learned that investors will not behave in the manner prescribed by charts and texts. Investors generally act in accordance with human nature. We do not know how to experience 10 and 20 year investment cycles – we feel, and react, in the present. We do not focus on our overall portfolio return – we cannot take our attention away from those specific components of our portfolio that are losing money. We know that buying an investment when it’s “hot” is unwise, but we can’t help jumping on the bandwagon any more than we can help cheering for the home team when they’re winning.
From a logical, rational perspective, we may understand the charts and statistics very well, but when our investments are declining in value, that understanding pales beside the intensity of our fear and anxiety. And to end the fear and anxiety, we react.
Marketing gurus know it best – we make decisions from our heart and stomach, and then justify those decisions with our head. The same is true of investing, and the result is that most investors make less money in the stock market than they would in a high yield savings account. We consistently buy high and sell low.
If we choose to avoid market risk and behavioural risk entirely, however, we run into other risks, other threats to our well-being.
To be continued…
“Money is a very excellent servant, but a terrible master.” - P.T. Barnum