Various aspect of Investment Risk
How often we go to an investment adviser and he tells us about the risk of our investment. The heart of the survey is trying to determine what risk are you willing to take. They will show us a graphic showing three scenarios of how your investment may look in a few years. It basically compares three types of investment over a certain number of year(s). The low risk (50% equity/50% bond) portfolio will show little to no downside and a small upside. The medium risk (70% equity / 30% bond) portfolio will see more some small downside and modest upside. The high risk (90% equity / 10% bond) portfolio will see huge upside and some downside.
For most people this is believed to be the risk they face when making an investment. Equity are risky since I may lose money, bonds are not risky, they may not lose money. I’ll pick the moderately conservative portfolio to try to get the average return, but will not receive the high end or low end result.
However, it’s all of these are not all true. And in the end, choosing a lower risk portfolio is accepting a sure and certain major decrease in the long run.
- Fact: You don’t lose money with Equity stock
When you buy a stock, it`s a thing. you don’t lose it if the stock price go down. If you have 100 stocks before the recession, you would still have 100 stock at the end of recession. However, bonds and equity alike, if the company who emitted it fails, you would lose everything. That’s why you should always diversified, else it’s gambling. Another exception for bonds and equity alike, if you sale it, you may sale it for less than you bought it.
- Fact: Bonds are risky, not riskless
It may come to a surprise to you but most bonds portfolio are 50% government bonds + 50% corporate AAA bonds. That is they hold either the government or blue chip company accountable for the return. Like above, if they fails (ex: Greece, Enron, mortgage backed), then you may loose 100% of your bonds value. Also like above, if they change price then you will loose money if you sale it (ex: increase in Bank of Canada rate, Decrease of AA+Status of USA). Both are likely in the near future.
Fact: Equity are riskier than bonds
Yes, equity are way more volatile than bonds. That means that day to day, or on any fixed point, they equity will be spread on wider range vs the mean versus the bonds.
Fact: Picking the moderately conservative portfolio will return on average substantially less than the aggressive portfolio.
While the number seems small a 1% rate of return difference is still 5k per year on a 500k fund. However, the power of compounding, the difference is greater. On a 5 years terms, the difference would be 90%. A fund of 700$ will grow to 1000$ using 7.5% or to 890$ using 5%. On a 20 years period the difference is enormous. 23 500$ would grow to just under 100 000$ vs 62 350$. That’s huge. It’s like accepting a year of -40% in your fund. That’s higher than the two worst recession we’ve seen.
That’s why I believe that the current risk profile questionnaire doesn’t truly reflects the real risk and return of the portfolio. Worst, over the long run it will trade the uncertainty of a loss for a certainty of a loss. I believe that there’s other way to help reduce volatility (although not directly) or to chance the way we see our fund.
In the end the portfolio allocation category choice is the third most important choice in investing. Right after, the choice to contribute, and the choice to contribute young. Remember folks “One dollar invested in stocks in 1802 would have grown to $8.8 million in 2003, in bonds to $16,064, in treasury bills to $4,575, and in gold to $19.75. The CPI has risen by a factor of 14.22, almost all of it after World War II.” — http://www.econlib.org/library/Enc/StockMarket.html