Managing the 10 Most Prevalent Investment Risks

This article takes a comprehensive survey of those investment risks that, as an investment advisor, I manage on an ongoing basis for my clients across the Greater Toronto Area.

Managing the 10 most prevalent investment risks:

Time Horizon – the amount of time you can spare to have your money tied up in an investment. Investment mismatch is where money that is earmarked for the short term is invested in a long term strategy and vice versa. The riskiest type of mismatch is where money is being saved for the very long term, 20 years or longer, and the portfolio is invested in short term investment strategies. This approach is a two for one deal, as it will eventually also expose you to another investment risk, inflation.

Inflation – when things get more expensive over time. Inflation can be the biggest silent destroyer of wealth over the long term. In Canada, our average annual rate of inflation has been 3.2% since 1914. This means that over a period of 22 years Canadian money can lose 50% of its original value due to inflation. Imagine saving for 30 years only to find that your purchasing power diminished much more drastically than you expected by the time you were ready for retirement. On the other hand, a reasonable amount of inflation gives rise to the increase in value of hard assets such as property, equity shares and some commodities. Investing in these harder assets helps to manage exposure to inflation, over the long term. Incorporating such assets into your investment strategy involves balancing financial planning requirements with tolerance for investment risk.

Interest Rates – the amount of interest you receive for lending money. Receiving interest income can be an important part of your investment strategy. But beware! Interest rates are a constant moving target that can erode the market value of your bonds, similarly to the equity market. In order to manage interest rate risk, bond portfolios must be properly constructed by diversifying within the various characteristics of all available bonds appropriate for consideration.

Liquidity – the ability to cash out of your investment anytime, easily and at a fair price. It’s hard to sell something when nobody wants to buy it. Worse is when there are enough distressed sellers in a market at any one time that they can drive prices down, farther and farther. In order to effectively manage investment risk involved with liquidity, I recommend diversifying investment portfolio holdings and never putting all your money into one single asset class.

Recessions – when the economy sucks! Recessions are a natural part of the economy. They can be very tough on people, I agree, but as investors they can present us with good buying opportunities and prepare us for the eventual spring or economic recovery. Opportunities to manage this risk present themselves, in part, because different countries can be at different points of the economic cycle at the same time and certain industries and sectors can experience a business cycle of their own. In basic terms, not everything gets flushed down the toilet at the same time.

Dominating Trends – when things don’t change over a long period of time. Underneath the general economic climate lies the main dominating trend of an economy or even a specific industry. This dominating trend, despite its ups and downs, generally leans in one direction over the long term. As an example, at one time the Japanese stock market was the darling of the investment world. In 1990, its dominant trend shifted downward. Investors who bought at the peak of the Japanese market in 1990, and held on to their investments, were still underwater 20 years later. Even though there were periods of growth along the way, the stock market failed to reach new heights. Typical investors that made money in this market were those that went counter to the traditional buy and hold investment strategy.

Volatility – the degree to which the value of your stocks bounces up and down. There is a direct relationship between the uncertainty of an economic climate and the volatility of certain investments. But, volatility is not necessarily an investment risk, in and of itself. For instance, if an investment doubled your money over a 6 year period, you might conclude that it was a great investment and not so risky after all. If, on the other hand, that 6 year period was so volatile that you had, not one but, several meltdowns, would you still agree that it was a good investment? In this example, the investment risk is about whether we will stomach the roller coaster ride or end up cashing in our chips before the time is up. Volatility leads to emotional investing, even for the hard core investors. Good portfolio construction manages volatility, as an investment risk. It strives to give investors a pleasant ride without sacrificing returns.

Bear Markets – when prices in the stock market have been hammered and everything looks gloomy. Bear market is actually an industry term. It’s when the stock market goes into a funk after a good long run. Bear markets can be short and shallow, or they can be long and deep. It’s difficult to predict the exact beginning or end of a bear market, but once you are in the bears’ den, running from the bear (selling low) is rarely a good strategy. Getting defensive helps to manage investment risk and prepare cash and investments for the eventual end of the bear market.

Bull Markets – when prices in the stock market keep going up and everybody is happy. Yes, believe it or not bull market is also an industry term. It’s the opposite of a bear market. The investment risk involved with a bull market is that it can make investors (and advisors) feel overconfident, thinking that easy money can be made without exposure to investment risk. Knowing when the bull market is about to end is also tricky. Finding newer and younger bull markets is, generally, the best way to manage investment risk when a mature bull market runs its eventual course.

Impatience – the restless feeling one gets when their investment isn’t going up fast enough and they sell too early. I cannot tell you how hard this investment risk is to overcome. It just is. If all the dots have been connected and nothing has changed to make an investment turn bad, then sometimes the best approach is to be patient and wait for the price to go back up.

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