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Understanding Risk
Types of Investment Risk and How to Minimize Them
When you're investing for retirement, your first impulse may be to choose the "safest" investment for your savings plan. After all, you want to do what you can to help make sure the money will be there for your future. But before making your investment decisions, it's important to understand the types of risk and to know that perhaps the riskiest thing you could do is not invest your money at all.
Types of Risk
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- Inflation risk is the chance the money you have invested will decline in value as rising prices shrink the value of the dollar.
- Principal risk is the degree of probability that your original investment will decline in value or be lost entirely.
- Credit risk is the chance a borrower will default on an obligation.
- Market risk (or volatility risk) is the likelihood that a broad investment market, such as the bond or stock market, will decline in value.
- Liquidity risk is the possibility you won't be able to sell or convert a security into cash when you need the money.
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The following sections detail market risk and inflation risk.
Market Risk
One common investing risk is the up and down movement in the value of an investment — its volatility. In short, a highly volatile investment has greater risk that its value may go down significantly in the short term. A low volatility investment has less risk that its value may drop significantly.
When you're investing for retirement, it may seem like you want to choose the investment with minimal short-term ups and downs. However, it's not that simple because there's another kind of risk to be aware of — inflation risk.
To keep up with inflation, you can invest in fixed-income investments, such as investment contracts and bonds, which are generally considered lower risk. They pay a relatively stable rate of return approximating the rate of inflation. The organizations that issue fixed-income investments — including highly rated insurance companies and banks, the government, and major corporations — tend to have a high level of creditworthiness, and therefore, less credit risk.
To do significantly better than inflation, you must be able to accept the risk of more variable asset classes such as stocks. The value of your investments will fluctuate more in the short term. But historically, stocks have consistently come back after short-term downturns and, over a typical market cycle, have outperformed nearly all other traditional investments in this century. Long-term, stocks have beaten inflation by a wide margin.
Inflation Risk
Perhaps the riskiest thing you can do is not invest your money at all. That's because you expose your money to inflation — the erosion of your money's purchasing power because of the rise in the prices of goods and services.
How Inflation Works
Inflation can best be described as the rise in the price of goods and services and equated with money's loss of purchasing power.
Inflation also affects income. As prices go up, income generally rises, too, somewhat negating, but rarely offsetting, the long-term impact of inflation.
Inflation's Impact on Investments
The following chart shows how inflation can eat up much of the growth of so-called "low-risk" investments over the long term.
Growth of a Dollar Invested
Jan. 1, 1955 - Dec. 31, 1999
Source: Stocks: TSE Industrial Index (1955-56), TSE 300 Index (1957-99); Bonds: 70/30 ScotiaMcLeod Long Bond Index / 91-day T-bills (1955-79); ScotiaMcLeod Universe Bond Index (1980-99); T-Bills: Canadian Institute of Actuaries (1955-59); ScotiaMcLeod 91-Day T-Bills Index (1960-99); Inflation: Canadian Institue of Actuaries (1955-1965); CPI (1966-1999)
Stocks: A dollar invested in stocks in 1955 grew to be worth a little over $94 by the end of 1999, providing over $88 in growth beyond inflation.
As you can see, over the long term, stocks historically have performed better against inflation than any other investment category. In fact, stocks have averaged a 10.6% return per year since 1955. This compares to a little less than 7.6% for bonds and 7.0% for Canadian Treasury bills.
Bonds and T-Bills: Between 1955 and 1999, a dollar invested in Canadian Treasury bills grew to more than $20 in value. A dollar invested in bonds had only slightly better growth.
Minimizing Risk
Time is on your side: Generally speaking, the longer your time horizon, the more risk you can accept in exchange for high returns. If your time horizon is relatively short, you may not be able to accept as much risk and may prefer more stable investments.
Remember: Most investments involve some form of risk. But so does doing nothing. It's important to understand the different types of risks and accept the one that best suits your needs. You can strike a balance between risk and return through a well-diversified portfolio.
Diversification — spreading your money among many different investments — is a widely accepted method of minimizing investment risks. For more information about minimizing risk, see Using Diversification to Combat Risk.
Nothing contained in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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