Deciding on investment depends on level of risk

There are a variety of risks we all face as investors, whether we invest in "risky" investments or not. Our job today is to define the different types of risks, and then examine the actual characteristics of volatility, showing the difference between long-term averages and short-term reality.

Any good investment salesperson will point out that GICs have reinvestment risk, and almost all fixed-income investments these days come with the risk -- and likelihood -- of loss of purchasing power.

Reinvestment risk is what you felt repeatedly between the mid-1990s and now, as your GICs and bonds came due and had to be reinvested at ever-falling rates. Loss of purchasing power occurs when your earnings after tax fail to keep pace with inflation. And, after all, what's the goal of most investing? To increase purchasing power over time, so your investments can pay for what your salary pays for now.

But those of us who are honest admit the granddaddy of all risks -- the one we and our clients feel most viscerally -- is loss of capital. Nothing stings like actually losing some money.

Let's quickly differentiate, though, between permanent loss of capital and temporary. Big difference.

Permanent loss of capital is supposed to only occur when you have consciously taken a risk with your money, by investing in something like a startup company, a junior resource play, small-cap stock or other such investment with high risk and high potential return. If you invest in such venture capital offers, you should know what you are in for.

With more conservative investments, such as shares of mature companies paying consistent dividends, such outright losses are not supposed to happen, and they seldom do. But a persistent reduction in share value can certainly occur, and this can carry on for years before recovery.

That's a reality of investing. Recent examples include Canada's insurance companies. Among other factors, they are as stung as you are by low interest rates and flat stock markets. As a result, investors have pushed their share prices down.

One job of an investment adviser (among many others) is to help you build a portfolio of good companies that can allow you to beat taxes and inflation with your investment returns, diversify such that the inevitable bad surprises are offset by more good, and then help you decide if the decline in a company's stock price is an opportunity, or something to avoid.

One more job -- perhaps the most important -- is to prepare you for the reality of stock market investing. Day to day, this is much different than the nine per cent long-term averages you might be shown, even though those averages are completely accurate.

To achieve those long-term averages, you must be able to ride out the short-term swings. To beat those long-term averages, you have to go against the grain and buy more shares when the rest of the market is saying sell. The market does this by driving prices down, sometimes violently, and this creates opportunities for the brave.

Where we fall down as investment advisers is not doing a good enough job of showing the extreme short-term returns -- positive and negative -- that make up those long-term averages and properly preparing investors for the ride.

I remember October 1987, when the markets crashed in one day like never before, aided by early computer programs. Not one of my clients called, because I had always told them, "At some point as an investor, you will see these investments drop 30 per cent. Don't panic, that's part of the pattern." Luckily, we had had that discussion before they invested.

Here are some facts. Please focus on the variations, rather than just the absolute numbers. A balanced portfolio of 50 per cent bonds and 50 per cent stocks from 1962 to the end of 2011 had an average return of 10.07 per cent over each 30-year period. But some 30-year periods were as high as 11.85 per cent, others as low as 6.81 per cent.

Over the 10-year periods, the average was 9.42 per cent, but varied between 3.14 per cent and 15.36 per cent. The five-year periods averaged 9.07 per cent, but varied between 19 per cent and 2.11 per cent. The three-year period averaged 8.81 per cent, but varied between zero and 18.8 per cent.

Here's the reality you need to internalize and remember. The one-year returns also averaged 8.85 per cent. We could all live with that. But the one-year actual returns have varied between positive 27 per cent and negative 12 per cent. If you start out with a negative 12 per cent return, and have no reserve money to put into stocks at that bargain level, you will likely also have a negative three-year return.

So be ready for these short-term disappointments, and know that they are part of those longer-term returns you need.

David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).

dchristianson@wellwest.ca

Republished from the Winnipeg Free Press print edition September 28, 2012 B5