Be Your Own Investment Manager Series - Part 4: Understand Risk and Return

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  by Ed

Enough small talk, let's do this.

Time to dive right in and actually talk about some investment options.  Sure, budgeting and debt reduction pay the bills, but you never see Multi-Budgetaires on the cover of Time nor do Masters of Debt Reduction get movies made about them.

Not yet anyways.

Risk and Return.  They roll off the tongue like Supply and Demand, Buy Low and Sell High and other business-y speak.  And just like those others, they are often poorly understood.

Let's start with Risk.

Risk is simply the uncertainty around a given investment's return.  It may go up (good) or down (bad).  The greater the 'risk' of an investment, the bigger range you should be prepared for between the two.

We generally focus on the Bad, as that is a better barometer for a person's Risk Tolerance.  We all have a pretty good Risk Tolerance when the market is going up (Bullish - if you ever wondered what that meant).  But when things go Bearish, how will you fare?  Will you be able to sleep at night?  Will you be able to think straight at work?

Understanding your own risk tolerance is important in determining your Asset Allocation (how much of which investments you should own).

Our good friends at the Investor Education Fund of Canada (IFIC) have created this Risk Profile Quiz to help you better understand yourself.  It weighs all the key factors - income, debt, dependents, investment knowledge, time to retirement and risk personality in 12 little questions and produces a summary about your investment personality.

Take a minute and do the quiz.  Then, print your results as you may want to refer to them in this next section.

Investment Options

One of the best tools for looking at your investment choices is this pyramid of investments.  Technically a "Triangle", as a Pyramid is a three dimensional shape, it nonetheless effectively organizes the types of Investments in order of Risk and Potential Return.

It also graphically conveys the concept that you should not be investing in anything until you have a solid foundation of Cash/Low Risk Investments.

This is my basic version without actual examples of investments in each level.  For the Keeners who want a sneak peak into Part 5, here is another Pyramid (also from IFIC) that does give you some idea of what constitutes a Low/Moderate/Speculative Risk Investment.

What neither pyramid can tell you is how much of each level you should invest in.  From looking at it, you would think most of your money should be in Cash, with a decreasing portion in each level going up.  This would be incorrect (and is my only real complaint about the pyramid model for displaying investing options).

Here is what you need to do.

Take your Risk Profile from above and compare it to the following table:

Risk Tolerance is another way of measuring someone's Risk Profile - it is the amount of Risk or Variability in Returns one can "Stand".  To see how this works, I'll pick a fictitious person - Robin.  Robin has $10,000 to invest and moderate risk tolerance.  Using the above asset allocation, the $10,000 breaks down like this:
  • $2000 in Speculative Investments
  • $4000 in Moderate Risk
  • $3000 in Low Risk, and
  • $1000 in Cash

Notice that as Risk Tolerance increases, the greater amount of Speculative assets an individual could hold in their portfolio.  However, we never reach a point where any portfolio is 100% Speculative or 100% Cash, no matter how much you like or dislike Risk.

Every portfolio needs balance and "Diversification" - we'll talk more about both of these concepts later.  Basically, everyone needs some Cash holdings for emergencies and "Quick Cash" needs and everyone needs some Speculative Investments to grow faster than inflation.

The above percentages are meant only as guidelines.  If you consider yourself somewhere between a Moderate and High Risk tolerance investor, go ahead and move 5% of your money from Low Risk to Speculative.  It is nice to have a baseline to start from, but everyone is different, so be honest and adjust to suit your Risk Profile.

Lastly - no Asset Allocation is a "Set it and Forget it" sort of thing.  It is a process that needs to be revisited every time your life changes in  major way.

  • Have kids?  Surprise - you can now tolerate less risk. 

  • Get a huge raise? You might be able to move some of that money into higher risk investments. 

  • Getting close(10 years) to retirement?  Time to recognise that you can bear less risk than you could before and start shifting a bit of money into Lower Risk investments.

Next Time: Outrageous Stock Tips to Beat Wall Street!  

Just kidding, but I will give you some low-cost, low-fee suggestions for each level in the Investment Pyramid and explain why I think they are good options.  In the meantime, check out your existing Asset Allocation.  Can you identify what is Low Risk and what is Speculative?

Keep reading...

The "Be Your Own Investment Manager" Series:

Part 1: Best Time to Start
Part 2: How Much and How Often to Invest
Part 3: Invest in Your Debt?
Part 4: Risk and Return
Part 5: Mutual Funds
Part 6: Simple Investment Options
Part 7: Saving for Retirement (RRSPs)
Part 8: The Colour and Psychology of Money
Part 9: Saving for Education

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