Why risk matters
As an investor, understand your risk tolerance. Risk is the potential to lose some or all of the money you have invested.
Risks of investing
You invest to earn a return on your money, but returns are not the only consideration. Risk and return are connected. Generally, the higher the risk of an investment, the higher the potential return. Here are some examples of how risk can affect investment return:
- You own a diversified portfolio of shares with a value of $100,000. There is a market correction and the value of the portfolio drops to $90,000. You have lost $10,000 as the result of equity risk.
- You own a diversified portfolio of bonds worth $100,000. The value of the portfolio drops to $95,000 because of an increase in interest rates. You have lost $5,000 as the result of interest rate risk.
Risk is usually perceived negatively as the potential to lose money. However, it can also have a positive side:
- You own a corporate bond with a market price of $10,000. The company has become financially stronger over time and its credit rating is upgraded. As a result, the market price of the bond goes up to $10,500. You have made $500 as the result of accepting credit risk.
- You own a diversified portfolio of U.S. investments with a market value of $100,000 in U.S. dollars. Given an exchange rate of 1.05 Canadian dollars for each U.S. dollar, the portfolio is worth $105,000 in Canadian dollars. The price of the investments in U.S. dollars remains the same but the exchange rate changes to 1.10 Canadian dollars for each U.S. dollar. The value of the portfolio is now $110,000 in Canadian dollars. You have made $5,000 as the result of accepting currency risk.
Learn about the different types of investment risk.
While there are no risk-free investments, the risk of loss with some investments is so small that it can usually be ignored. For example, Canadian treasury bills, a form of short-term government debt, have very little risk of loss – the risk of the Canadian government going bankrupt over the investment term is very low. Because their risk is so low, treasury bills are virtually risk-free.
Some investments, such as common shares, carry much greater risk. When you buy common shares, your return is uncertain – it will depend on the future price of the shares. There is a possibility that you will not get the return you are expecting or that you will lose money.
Share prices move up and down, which means that the return in a given year can vary considerably. A stock price that changes quickly and by a lot is more “volatile”. This makes a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition riskier – you could lose a lot if you had to get your money out on short notice. The more an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition‘s price has varied from the average price, the greater its risk. This variability of returns is known as volatility. Learn more about volatility and how it’s measured.
An investment’s volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition provides a good indication of the chance that it will lose money. When annual returns vary widely, there is more of a chance that the investment will lose money in any given year.
Using volatility to measure risk
Tim and Marie both own diversified portfolios. Tim’s portfolio has an average annual return of 5%, but the actual return in a given year usually falls anywhere between -5% and 15%. Marie’s portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition also has an average annual return of 5%, but the actual return in a given year usually falls anywhere between -10% and 20%. Marie’s returns are more volatile than those of Tim so her portfolio is riskier.
The risk of not taking enough risk
While risk can mean that you have a greater chance of losing money, it can also be measured by the potential for lower returns than what you need to achieve your objectives. If you don’t take enough risk, you may not make enough money to meet your investment goals.
For example, if you decide you need an average annual return of 6% in order to meet a financial goal, and you invest in low-risk investments that only pay 3%, you won’t lose money but you won’t meet your goal.
If your goal was to retire comfortably, the lower return might mean that you need to delay retirement or accept a lower annual income in retirement.
It’s possible to take too little risk. If you don’t take enough risk, there is a greater chance that the return on your portfolio won’t be enough to meet your goals in the long term. Consider your risk tolerance.
Pay attention to risk as well as return. If you focus only on achieving the highest possible return, you may not recognize the risk you are taking.
Every mutual fund provides a document called Fund Facts for investors. This includes the fund’s risk rating, based on the past volatility of the fund’s returns.