On Topic

Investing and Managing Risk

Investment is really about management of assets on a great sea of risks. One hears stories of folks who have made a fortune on a daring play with a big bet on a hot stock or lost it the same way. In each case, the investor was exposed to substantial risk. That's no way to run a portfolio for retirement or as a way of carefully building a family fortune.

There is risk in every action or inaction one can take. The investor's dilemma is compounded by the question of asset allocation. In the simplest case, it comes down to how much money to commit to any investment whether a GIC that will keep funds safe, though never generate much of a return, or a promising but risky play in a stock that few have heard about.

The varying risks of investments

For safety, GICs, treasury bills, and, for that matter, deposits at financial institutions are low in risk, but they are also a painfully slow way to make money. If one gets 4.5% per year for a five-year deposit, $45 per thousand dollars, then, putting it another way, one has to invest $1,000 to get just $45 before adjusting for taxes and inflation. If inflation is 3.0% per year, one is left with 1.5% as a return on the $1,000 and, if the account is taxable, then it will be certain to provide a taxable real return of exactly -0.5% per year. This is an investment appropriate only or investors with short term objectives, such as making a house down payment, in the near future.

At the other extreme, one can invest in a stock that appears to have a 20% annual return. In some years, the stock will go down more than the market average and in other years, it may rise more than the market average. Assuming that it rises 15% in 3 out of 5 years, then its payoff expectation is .15 x 3/5 or 9% before inflation and tax. If you have the ability to watch this stock gyrate without getting emotional, it may be a good investment that returns an expected $90 per thousand over the long run, assuming that you can reinvest the 9% expected return each year at the same rate.