What You Need to Know About Risk
Hearing the word “risk” can make people as uncomfortable as when they hear other four-letter words. That’s because the person hearing the word may be attaching a different meaning than what the person using the word intended. An understanding of how the word risk is used and what can be done about it will make it a lot less scary. Here is a list of some of the many ways the word risk can be used in the world of investing and financial planning.
− Volatility is the degree to which investments go up and down in value in the short term. An investment that goes down 2 percent one day and up 2 percent the next is deemed to be higher risk that one that goes up and down 0.1 percent.
− Uncertainty is an outcome that cannot be known or predicted. For example, if you buy a stock, you cannot know for sure how that investment will perform. Also, you cannot know if interest rates will move higher or lower, or if the value of the Canadian dollar will increase or decrease. Depending on your situation, these uncertainties could be a risk for you. Even the length of time you might live could be considered a risk. You can’t know for sure if you will live to be ninety or a hundred, so planning how long your money will last carries what we call longevity risk.
− Something can go wrong. You could buy shares of a strong, successful company, but it could have a bad year or run into unexpected problems.
In life, there are all sorts of risks. Driving your car poses the risk that you could get into an accident. You understand that and you take steps to reduce it. You drive carefully. You watch out for other drivers. You wear your seat belt. You have insurance. And sometimes, such as when the weather is poor, for example, you don’t drive.
Investing is very similar. You must recognize the risks, avoid them if you can and take steps to reduce them when they can’t be avoided. The important thing to ask is whether it is a risk for you. If so, is it big or small? What can be done about it? Are you comfortable with it? Does it matter that much?
Volatility is the most commonly discussed risk. There is a trade-off in investing. Investments that go up and down a great deal are the ones that generally give you a higher return in the long run. Investments that are stable, with fewer short-term changes, usually give you a lower long-term return. Your ability to cope with volatility may have changed, depending largely on how much you are relying on your investments to meet your everyday needs. If you have pension income that is enough to cover your expenses and your investments anchor your financial stability and help deal with unexpected expenses, then you may feel comfortable with investments that have greater ups and downs with the expectation that they’ll provide higher returns.
If you are using your investments to supplement other income and to help cover your expenses, you may feel more comfortable choosing investments whose values do not fluctuate so much in the short term since there is a greater chance that you will need your money sooner. In this case, volatility would be a greater risk for you.
Taking money out of investments when their values are down uses the money up faster. For example, if you had $100,000, it grew by 10 percent to $110,000 and you needed to take out $10,000, you’d still have $100,000. If that $100,000 then grew by 10 percent, it would be back up to $110,000. If instead your $100,000 fell by 10 percent to $90,000 and you took out $10,000, you’d be down to $80,000. If it then grew by 10 percent, you’d only be back up to $88,000. Taking money out when investments are down puts a dent in what you have. An investor who uses or may need to use her money must try to limit ups and downs to help protect her savings.