Risk can be defined as “the possibility of something bad happening”. It’s an important consideration in many of our decisions and often most of us will try and reduce it or avoid it when we can.
While avoiding risk can often be the most sensible thing to do, in the context of investing, avoiding risk altogether may expose you to other, less obvious, risks. Successful investing depends on understanding key risk factors long- term investors face, how they can be managed, and assessing your own capacity and tolerance for risk.
Successful investing is about managing risk, not avoiding it.
Risk can be a loaded term when it comes to investing and is often misunderstood. You often hear about risk and volatility interchangeably in investing; while the two concepts are related, they don’t mean the same thing. Risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision, whereas volatility measures how much the return of an investment, or the broader market, fluctuates up and down.
This article puts different investment risks into perspective and explores the various ways they can be managed.
Understanding investment risks
1. Inflation Risk
Have you ever heard someone say, “When I was your age that only cost a dollar”? They are referring to inflation – the general increase of average prices in an economy, accompanied by a decrease in the purchasing power of money.
When saving for a long-term goal, we typically plan for the future while being very much rooted in the present. But the cost of goods and services – everything from groceries, to your morning coffee – will look quite different by the time you retire compared to when you started saving. Factoring in inflation is an important consideration when completing a financial plan.
A nickel ain't worth a dime anymore.
2. Market Risk
Market risk is associated with fluctuations in the market as a whole, rather than a single stock or a business sector. Typically, when we think about market risk, we can become very focused on the day-to-day movements in the markets and the corresponding change in the value of our investments, with a heavy emphasis on recent activity. However, when you look at the markets through a wider lens, the picture offers greater optimism. From the chart below, it’s clear that downturns have historically been followed by sharp recoveries. While it can be tempting to flee to the relative safety of cash during periods of volatility, remaining disciplined and staying focused on your long-term goals usually nets a better result than attempting to time the markets.
Key Resource
Market volatility can be unsettling for even the savviest of investors. For tips on how to manage – and potentially benefit from – market volatility, check out 5 Timeless Tips on Managing Market Ups and Downs.
3. Longevity Risk
Outliving one’s savings is a real risk for many, especially as life expectancies rise. The illustration on the right shows that an average female in Canada will spend 22 years (19 years for males) in retirement, but it’s important to recognize that these numbers are just estimates and a sizable percentage of Canadians will end up living a great deal longer. With longer lifespans, your exposure to inflation risk, health risks and the risk of running out of money increases.
For many, outliving their retirement savings is a very real risk, but one that can be managed with proper planning and the right balance of investments for each stage of one’s life. For many, outliving their retirement savings is a very real risk, but one that can be managed with proper planning and the right balance of investments for each stage of one’s life.
Average years spent in retirement in Canada (1960 vs 2019)
Managing Risk
It’s important to remember that risk is an inherent part of investing. You cannot eliminate risk associated with investing, but you can certainly manage it. Here are some strategies to help you manage risk:
The biggest risk of all is not taking one
Diversification - Don't put all your eggs in one basket
Diversifying a portfolio by combining different asset classes such as stocks, bonds, and cash equivalents – a process known as asset allocation – can help reduce your overall portfolio risk and lower the impact of day-to-day market volatility. This occurs when some assets perform poorly, their losses may be offset by others that are performing well. The chart below shows the best to worst performing asset class each year since 2011. As you can see, no single asset class is consistently among the top performers, and the best and worst performers can change from one year to the next. A balanced portfolio with exposure to a variety of different asset classes provides the opportunity to participate in potential gains of each year’s top performers, while aiming to lessen the negative impact of those at the bottom – smoothing out the ride.
Each Scotia Portfolio Solution maintains an optimal asset mix consistent with each investor’s risk tolerance, while active management and multi-level diversification take advantage of emerging opportunities while managing risk along the way.
Time - Use time to your advantage
Although contributing to long-term investments (e.g. retirement) is Canadians’ leading financial priority1, there always seems to be a good reason to delay saving. The reality is that time is your biggest ally when it comes to saving and it’s never too early to start saving for retirement. You can start by contributing even a small amount each month. As you earn more later in your career, you can increase the amount. The earlier you start saving, the better off you’ll be, as your money will have more time to benefit from compound growth.
Time is on your side
Let’s look at the impact of delaying saving for retirement. Susan and Mark would both like to retire at age 65. Susan starts saving $100 biweekly when she’s 30. Mark decides to put off saving until he’s 45 but will contribute twice as much – $200 biweekly – to help catch up.
At age 65, Susan will have contributed $91,000 in 35 years, while Mark will have contributed $104,000 in 20 years. However, Susan will retire with $64,510 more than Mark – even though she contributed $13,000 less. With more time on her side to grow her savings (15 years more) and the benefit of compound growth, Susan’s $91,000 contribution grew to $240,882, while Mark’s $104,000 contribution grew to $176,372 ($64,510 less than Susan).
Investing regularly and automatically with Pre-authorized Contributions (PAC) can help you build your savings easily and automatically.
Your risk tolerance and investing
The degree of risk you’re willing to accept when investing is a critical factor in building a successful investment plan. Just like some people may find bungee jumping thrilling, others would rather have their feet on the ground. While an aggressive investment strategy can be too much for many to stomach, an overly conservative approach can hinder growth potential and increase the risk of falling short of goals, especially after factoring in inflation.
The bottom line: Having the right investment approach and asset allocation for your needs can help strike a balance and manage risk, instead of avoiding it.
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