Given that today’s bank savings rates are close to nil due to historically low interest rates, Canadians will likely need to explore other options outside of guaranteed investments to achieve their retirement goals. In so doing, they will need to be comfortable with risk.
In the context of investing, risk can be defined as “the loss of money due to negative fluctuations in investment value.”
Risk: Why take it? And what level of risk is right for your savings?
Investors risk their hard-earned savings in riskier investments with the expectation of earning a higher rate of return than less risky investments. Typically, investors require higher rates of return to reach their financial goals, or else those goals may be negatively impacted.
There are two key factors that should dictate how aggressive (or risky) you should be with your savings):
- your ability to take risk (i.e., factual details about your finances)
- your willingness to take risk (i.e., your attitude toward risk and potential losses)
When combined, these factors provide your “risk tolerance” (i.e., the amount of investment loss you can tolerate and not panic).
What are the risks of different investment types?*
Traditionally, there are three types of investments:
- equities (stocks)
- fixed income (bonds)
- cash (or cash equivalents)
These three groups of investments are called “asset classes,” which are groups of investments that exhibit similar characteristics and move similarly in the marketplace. These three asset classes are the predominant choices for Canadian investors, whether completed directly or indirectly through a mutual fund or exchange traded fund (ETF).
Equities (stocks): ownership interest in a company that generates return through stock appreciation / depreciation and dividends.
Example: Royal Bank of Canada
Risk: high, highest of the three assets classes discussed in this article
Expected returns: approximately 5% compound average growth rate over the next five years for large blue-chip Canadian companies
Reasons to own: increased cash flow through dividends, protection against inflation, participation in economic growth via capital growth in stock value
Bonds (fixed income): loan made to a company or government with a stated rate of interest and maturity date.
Example: Government of Canada bonds
Risk: medium, second most risky of the three asset classes listed here
Expected returns: approximately -0.5% compound average growth rate over the next five years for the broad Canadian bond market
Reasons to own: insurance from market fluctuations, ability to know the value of the investment at a future date (maturity), steady predictable income
Cash (or cash equivalents): certainty of value with no fluctuations, which pays interest but usually at a lower rate than bonds.
Example: high-interest savings account
Risk: low, lowest risk of the three asset classes discussed here
Expected returns: close to +0.5% compound average growth rate for the next five years
Reasons to own: certainty, liquidity to pay for living expenses, ability to purchase other investments quickly
* Estimate source: BlackRock Investment Institute, Capital market assumptions (https://www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions).Individual investments listed are for example purposes only.
Historical returns for asset class returns
Why would anyone want to invest in low-returning investments, as described above for bonds and cash? The answer is risk tolerance. Treating your investments like a horse race, where you are trying to pick the winner every time, typically leads to suboptimal outcomes. Instead, investors typically have a mix of investments, called “diversification,” that helps them customize their investments (or “portfolio”) to be more in line with their specific risk tolerance.
Should the market fall, the diversified investor is more able to stick to their investment strategy. This compared to the investor always trying to pick the winning stock (“horse”) but not able to tolerate the risk involved with that strategy. This typically leads to investors making poor decisions based on their emotions.
Below is a table of the three asset classes over the last five years. The main point the table illustrates is that returns fluctuate year to year, and different asset classes perform better or worse in different years. So, picking the winner each year is difficult for even the best investors.**
Which investment is best for you?
Like most things in life, it depends. The level of risk that you want to take on with your investment savings is unique to your personal financial situation and personality. This detail is most likely captured in your personal financial plan. It is likely that the right investment for you is a mix of the three discussed asset classes in varying proportions, to align with your risk tolerance.
A financial advisor can help you to first create a financial plan unique to your personal situation, and then marry that plan with an investment strategy that takes into consideration your goals, risk tolerance and financial situation. Every year or two, repeat this exercise and rebalance your investment portfolio to suit your risk tolerance at that time. This will make you much more likely to meet your financial goals – so that when you retire, you can focus on what matters most.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.