Understanding and Managing Investment Risks

In my experience, the best investors are the ones who take the time to be informed and understand as much as possible. You don’t need to be an expert, but with knowledge comes comfort.

One area of investing that is often misunderstood is risk: What it is, where it occurs, how it can hurt you and of course how to control it. These are all critical elements for your investment success. So, let’s explore the top five risks we see most often among investors, the impact they can have and how to control them.

Here are the top five risks investors often face:

1. Market Risk: This applies to various markets like stocks, bonds, and real estate. Each has its own set of risks. For example, the stock market can experience short-term declines, which are normal and happen annually, even in good years. Despite these drawdowns, full-year returns have been positive 75% of the time since 1980. Diversification is key to reducing market risk and achieving smoother returns over the long term.

2. Concentration Risk: This risk involves putting all your eggs in one basket. While many investors believe they are diversified, they often face concentration risk without realizing it. For instance, having a significant portion of your portfolio in a single sector or geographic region can expose you to higher risk. Many Canadian investors hold 52% of their investments in Canadian stocks, missing out on global opportunities, as Canada only accounts for about 2.7% of the total global equity market. Diversification across different asset classes, sectors, and regions can help mitigate this risk.

3. Liquidity Risk: Liquidity risk is the risk that an asset cannot be quickly converted into cash without a significant loss in value. This may mean not being able to meet cash flow needs or cover emergencies. Understanding your short-term needs and ensuring that portion of your portfolio is in liquid assets, like cash or easily tradable securities, can help manage liquidity risk. By making sure you have available money to cover emergencies and upcoming financial needs, you can confidently invest for the long-term without fear and market distractions.

4. Longevity Risk: Longevity risk refers to the risk of outliving your savings and investments. People are living longer and healthier lives. In 1970, the average lifespan was around 72. Today, if you retire at 65, you can expect to live to 86. A common retirement myth is that you’ll need much less money in retirement than when you were working. However, retirement income needs are closer to 80-100% of your working income, especially if you plan to travel and stay active. Planning for a longer retirement and adjusting your savings strategy accordingly is crucial.

5. Behavioral Risk: Our emotions and biases can lead to poor investment decisions. This risk comes from our actions, not the investments we own. Common biases include trying to time the market (herd mentality), panic selling (loss aversion), and holding onto investments too long (anchoring). Successful investors avoid these biases by making disciplined decisions and sticking to their investment plan. Being aware of these biases and having a strategy to counteract them can help manage behavioral risk.

The best way to manage risk is through a disciplined process. Start with your current situation, future plans, and risk tolerance. Design a financial plan and investment strategy to reach your goals, and stick to it. Regularly review and adjust your plan as needed to stay on track.