All investments come with risk. Before you start investing, it’s a good idea to understand the risk-return relationship and how to determine your investment risk profile.
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What is the risk-return relationship?
All investments carry some amount of risk. Risk refers to exposure to potential financial loss. Generally, the higher the potential return an investment offers, the higher the risk. But there is also a higher chance you could lose some or all of your money. Lower risk investments tend to have lower potential investing returns — and a lower risk of losing your money. This is the risk-return relationship.
Investments have different levels of risk. For example, guaranteed investment certificates (GICs) and bank deposits are considered low risk. That’s because you are offered a guaranteed rate of return, and they are backed by large financial institutions.
On the other hand, stocks often have a potentially higher return over the long term than an investment like GICs, but they are also riskier. As a shareholder — who owns stock or shares in a company — if the company is unsuccessful, you could lose all of your money. But if the company is successful, you could receive higher dividends, and the value of your shares could rise.
Other investments such as those sold on the exempt market are highly speculative and considered to be very risky. They should only be purchased by investors who can afford to lose all of the money they have invested.
One way to manage risk in your portfolio is through diversification. That means choosing a mix of investments with different levels of risk exposure. Diversification can reduce the risk of your portfolio without sacrificing potential returns.
How do you determine your risk profile as an investor?
Knowing your risk profile is important for making investment decisions. There are two key parts to your risk profile:
- How much risk you are willing to accept — your risk tolerance.
- How much risk you can handle financially — your risk capacity.
Knowing how much risk you’re willing and able to handle is a fundamental part of investing. It will help you decide whether an investment is right for you, and also whether you have the right time horizon for your investing goals.
Your overall risk profile reflects where you have concerns. For example, if you have low risk tolerance but high-risk capacity, your overall risk profile would be considered low. This would guide your investing decisions. If you have a low risk profile, you will likely choose a safer, lower risk portfolio with lower potential returns.
If you have both high-risk tolerance and capacity, you have a high-risk profile. This means you will likely choose a riskier investment for your portfolio with a higher potential return.
Managing risk is a personal and financial balancing act. Most people want their portfolio to have the highest return, given the highest risk they can accept and endure.
If you work with a financial advisor, they will ask you questions to understand your risk profile as well as your investing goals. They may ask questions such as:
- When do you expect you will need the money you are investing?
- Do you have any large purchases you’re saving up for, such as a car or a home?
- If the value of your portfolio dropped by 20%, how would you react?
- How would you describe your level of investing knowledge?
Knowing the answers to these questions will help you ensure your advisor is working with your level of risk in mind.
These are also good questions to ask yourself if you’re a DIY investor and mostly invest on your own. One of the potential risks of DIY investing online is that it can be easy to make investing decisions quickly or impulsively. If you keep your risk profile in mind, you can make sure you’re being guided by your own needs rather than fear of missing out.
Remember:
Risk is both financial and personal. Your risk profile includes both your ability and willingness to tolerate risk.
How much risk are you able to take on?
Your risk capacity is about whether you would be okay financially if you lost more than expected in a risky investment. In other words, if you lost some or all of your money unexpectedly on an investment, would you be forced to reduce your standard of living? Your answer will help you understand how much risk you can handle, financially.
Your ability to handle risk depends on your wealth, including:
- Your financial wealth, such as investments and savings.
- Your human capital, meaning your ability to earn income from work — which can help cover investment losses.
Is investing $10,000 a lot of money? Wealthier investors can usually take on more financial risk than those with more limited financial resources. Picture these two different scenarios:
- Susan is 24 years old and knows a lot about investing. She has no outstanding debt and expects to work for about 40 years before retiring. As an investor she has the time and income to make up for losses, so she feels comfortable investing $10,000 in a higher-risk portfolio.
- Jamal is 69 years old and recently retired. He has a limited monthly budget for expenses. His current investment portfolio provides him with enough income to cover his monthly spending needs, but not much more. As an investor he cannot afford a loss of $10,000 without risking his monthly income. He does not have the time or income to earn back losses.
It’s ideal to have some savings as well as your investments. Having an emergency fund set aside will help you cover a surprise expense without having to liquidate investments or take on new debt. If you’re just starting a savings habit, try one of these ways to find money to save.
How much risk are you willing to handle?
Your risk tolerance is about the emotional or personal side of investing. If the level of risk in your portfolio causes you stress, you may have investments with more risk than you are willing to tolerate. To reduce your stress, you might consider making your portfolio less risky.
It can be easy to overestimate your willingness to tolerate risk when markets are up. But it’s important to consider how you would handle a downturn, or a significant loss to part of your portfolio. Consider the last time you had a significant investment loss. How did you react? If you had trouble accepting the loss, or perhaps lost sleep over it, consider reducing the risk of your portfolio.
Risk-taking varies amongst Canadian investors. Whether you identify as a lower-risk or higher-risk investor, you are not alone. Risk-taking behaviour is influenced by many things, including past investment experience, investing knowledge, time horizon, and beliefs about the future.
Research shows that overconfidence can often lead to higher levels of risk taking. Learn more about overconfidence and how this behavioural bias might influence your portfolio decisions.
When could your risk profile change?
It’s normal for your investing needs and risk profile to change as your life changes. Whenever you have a major change in your life, such as getting married, changing jobs or buying a home, it’s a good idea to revisit your risk profile.
You can talk to your advisor about changes in your life that would affect your investing decisions. If you’re managing your portfolio on your own, assess your portfolio every year to ensure you’re still comfortable with the risks you’re taking.
Your risk profile might need to be updated if:
- You had a major life change that affects your level of wealth, cash flow, or savings.
- Your investing time horizon changed – for example, you now expect to retire five years sooner.
- What you’re investing for changed – for example, you’ve decided to save for a home as well as for retirement.
- Your personal preferences towards risk changed – for example, you’re feeling worried about your portfolio on a regular basis.
Two people in similar situations may have very different risk profiles. It’s important to understand your appetite for risk when creating your investment portfolio. Ideally, you want to adopt a strategy that you can be comfortable with over the long term.
Our individual behaviours are prone to bias. That can make financial decisions challenging. Try our behavioural bias checker to understand more about your financial decision making.
Summary
All investments come with risk. Your risk profile is an important consideration when making an investment decision.
- All investments come with risk. Your risk profile is an important consideration when making an investment decision.
- Your risk profile considers your capacity and tolerance for risk.
- Your risk capacity is about how much financial risk you are able to handle. In other words, if you lost some or all of your money in an investment, would you still be able to make your everyday financial commitments?
- Your risk tolerance is about how much risk you are willing to take on. In other words, would you lose sleep at night if your investments dropped in value by a significant amount?
- If you work with an advisor, they will ask you about your risk profile along with your investing goals and needs.
- If you are a DIY investor, knowing your risk profile is also important as a way of helping you make the investment choices that are right for you.
- Your risk profile can change over time as your life changes.
