July 14 , 2021
When it comes to investments, the risk-reward relationship is far from linear. Here's what you need to know about managing investment risks.
Most of us have heard the phrase “higher risk, higher reward” and we assume it’s a simple progressive relationship between the potential rewards associated with a particular action and its inherent risks. When it comes to finances and investments however, the relationship is far from linear. The initial moderate risks incorporated into your investment portfolio increases your expected performance greatly while taking on additional higher risks usually means a disproportionate increase or even a decrease in expected returns over time, leading to unnecessary risk.
Regardless of your personal relationship with risk, it’s important to remember that most investment risks can be managed to appropriate levels for most investors.
What are the types of investment risks?
First, it’s important to recognize that saving and investing have two very different sets of risks associated with them. Saving Risks are mostly associated with not reaching your goals. These would include longevity risk - the risk of outliving your savings as well as reinvestment risk, inflation risk - the risk that the cost of living outpaces your investment returns, reinvestment risk - the risk of reinvesting capital and investment income at lower rates, and horizon risk - the risk that you are required to sell investments before you initially intended at a lower value than if you could hang on to the investments. These savings risks can be managed through proper financial planning, discipline, and advice. Having a financial plan that is adaptable and accounts for these specific risks and can prevent them from negatively impacting your financial success.
Investment Risks are measured by the chance that an investment returns, or outcomes are different than what was expected. Traditional investments like stocks and bonds carry varying levels of market risk - the risk that the value of investment assets decreases in value due to events affecting the entire market and economic conditions. Market risks include equity risk - the risk that share prices in general will fluctuate(also referred to as volatility risk), interest rate risk - the risk that a change in interest rates impacts the value of an investment, currency risk - the risk that exchange fluctuations impact the value of an investment and commodity risk - the risk that commodity price fluctuations impact the value of an investment. Market risk can be managed by understanding your tolerance for risk and developing investment plans and policies to limit how much market risk you should expose your investments to while still generating enough returns to meet your goals.
Picking individual investment securities also has its share of unique risks to consider and manage. Security selection risks include liquidity risk - the risk of not being able to sell your investment when you want to, concentration risk - the risk of loss when all your savings are invested in the same type of investment, credit risk - the risk that a debt issuer defaults on their interest or capital payments and foreign investment risk - the risk of loss from investing in foreign countries or even domestic political risk, the risk of adverse changes to legislation or regulations (think pipelines). These risks can be managed by using appropriate portfolio management strategies, comprehensive security analysis and appropriate proper diversification.
As you can see, there are many risks to consider when investing your savings. Most of these can be managed by applying simple yet important strategies like diversification and hiring a professional to help manage your investment portfolio. In my next article, I will take a closer look at some of the strategies used to manage investment risks.
More articles from Marcel LeBlanc:
Author:
Marcel LeBlanc, CFP®, CIM® is a Financial Planner and Associate Portfolio Manager with Louisbourg Investments. You can find more from him on Facebook and LinkedIn. Comments or questions may be submitted to Marcel at marcel.leblanc@louisbourg.net, or he may be reached at (506) 383-5204
This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. If you are not sure how to proceed with a request for further information, seek help from a professional. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments.