The Risk Level of a Portfolio
What do you think of when you think of October? Sunny, crisp autumn mornings, the bright colours of the autumn leaves, princesses and goblins getting excited or—Black Monday, Stock Market Corrections, Black October. There is always the fear of a large market correction; that is why it is so important to ensure that your portfolio is aligned with your risk tolerance and is diversified across the various asset classes.
Depending upon your objectives and time horizon, you may have to give a little and accept more risk in order to achieve your goals. The risk spectrum does not go straight from 0 to 100, there are many varying degrees of investments in between, and with an understanding and knowledge about some of these options, and you may find that your risk tolerance is not zero after all.
When we talk about the risk level of a portfolio, we have to consider many scenarios; What is the likelihood: of your capital being preserved? of the earned interest/dividends being paid out to you? that you will be able to withdraw funds during retirement without depleting your capital and for how long? that you are able to withdraw funds in an emergency without penalties or the risk of capital losses? Determining your risk level is more than marking a box on an application form.
Through discussion it is very important to ensure that you not only know the difference between low and medium or medium and high risk, but that you understand the limitations and consequences of your choice. Everyone would like no risk and high interest, but, unfortunately that is not how portfolios can be built. The more comfortable and knowledgeable that you are with your risk tolerance, including the consequences upon your savings, the less likely you will be to give a little shudder—shut your eyes—when you turn over the page in your calendar to October.
I mentioned diversification earlier. Diversification of your portfolio across the various asset classes is a way to lower the risk of your portfolio. Over the past 30 years, no one- asset class has continually outperformed the others. At one time I can recall reading a study that compared the tactic of buying the previous years ‘winner’, annually, to the tactic of buying the previous years ‘loser’ year after year. Over 20 years, the difference between the final portfolio returns was minimal.
Broadly, the asset classes are cash, fixed income, equity and specialty investments. There are numerous sub-headings such as bonds, Canadian or U.S. equity, dividend and income trust funds, gold and other precious metals to name a few. Studies have determined that approximately 90% of a portfolio’s return is dependent upon the diversification, not on market timing or being able to pick the ‘winners’.
There are many ‘GIC only’ investors. They don’t want to take any risk, and their portfolio is 100% fixed income and cash (a GIC with less than 3 years to maturity is considered cash). Although this is not considered a diversified portfolio, this mix achieves a client’s objective of safety and income with no risk.