20. Understanding Investment Risk

Transcript

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. 

Today, and for the rest of summer here, we're going to be starting a summer series where I'll have more frequent, shorter episodes on the topics of investing smarter and reducing taxes. 

Joining me on this first episode of this new series is Steven Guenther. You've seen him before on some of my other episodes on RESP’s and credit cards. We're going to be trying something a little bit different here, we're going to be talking about risk today.  

Steven Guenther: Thanks for having me back, Evan.  Always a fun time when we get to chat. 

Evan Neufeld: Yes. Especially about risk. Okay so when you think about investment risk in particular, what are some of the things that you think about? Or how should people think about risk? 

Steven Guenther: I guess the starting point is how do you measure risk? And I think the standard answer is something called volatility, which is a pretty rough measuring stick at best.  But what volatility speaks to is basically the changes in prices of an asset over both the intensity or the what's the word I'm looking for. 

Evan Neufeld: It's just how far it's moving in any direction over a period of time. Yeah, it depends on what you want to look at.  Not to bring everybody back to stats class here, but the metric that you can look at is something called standard deviation.  So if you have an average over a period of time, the larger  the standard deviation, the wider those gaps between what you could expect year to year would be.  

Steven Guenther: So I mean that's an interesting point because naturally when you're investing, you want upward volatility.  

Evan Neufeld:  If I would have 6%, I'd love to get 25%. 

Steven Guenther: So there's different ways to looking at it, but a better way of looking at it is looking at downside volatility on its own and stripping out the upside volatility, which we want. Because if you look at just volatility in a general sense, just changes in price over a certain amount of time, then you're really not capturing what the risk of the investment is.  You're just looking at changes in that price.  So downside volatility will give you a better indication of how risky an investment may be.  

Evan Neufeld: And I guess when we're talking about risk here, we're generally using the concept of risk as it relates to a diversified portfolio. So they're using things like mutual funds and ETFs. But if you're investing in individual stocks, you always have that risk of a permanent loss of capital, forever.  That stock could go to zero.  

Steven Guenther: That's probably another way of thinking about it in a more realistic sense, because yes, volatility is going to happen in any type of market based investment, but at the end of the day, when you sell it, is really what determines your outcomes. If you're selling it, when it's up, you're going to make money.  Sell when it's down, you've lost money, based on your original principal you've invested. If you're looking at individual securities, certainly bankruptcy is a potential thing, which would mean that you're getting cents on the dollar or possibly nothing on the dollar for when it comes to your principal.  And that is of course true risk, losing your money. Volatility in a sense is just changes in your money, it's not losing it.  

Evan Neufeld: So now when people talk about risk, the other side of the coin is always returns. So risk and return, risk and reward. How does that relationship work overtime?  

Steven Guenther: Well, if you think about what risk is, naturally if you're going to take a risk, let's say in the small business, you're going to open a business. You're going to take a risk; you're putting some of your own money at play. You're hoping to generate some sort of return on your original investment in that business.  

So for someone who isn't going to take that leap and has their money, let's say in safe places like their house or a savings account, naturally you're not going to see a huge return on that, but you get the security that comes with having it in a very safe asset. Whereas if you think about like a small business or when you invest, you're taking on the unknown and the unknown in itself requires some level of return over and above, we call maybe a risk-free rate. Because otherwise, why would anybody take any risk at all? If you could do just as well in a savings account, that's guaranteed. So naturally for anybody to invest in anything, there has to be a reasonable expectation of a return higher than the risk-free rate. And so the more risk or the more out there, maybe your idea is, the higher, you have a potential reward for it to be a good decision. 

So that's a relationship that's at play in all asset classes, in all decisions really, especially when it comes to investing.  

Evan Neufeld: I think the keyword that you mentioned there was potential return, because people think risk and reward, but there's always the risk component and the risk is you could still lose it or it could decrease in value.  That's the risk component, but you'd hope that depending on what it is, it should have the potential to increase over a longer period of time. So when I've often thought about risk, risk is the chance that there's a short term disappointment in exchange for potential long-term gain or growth or profit. 

I don't know if that's the best way to look at it. But when you increase your risk, it doesn't always immediately reflect in increased immediate reward.  

Steven Guenther: Just opens the gate to a potentially higher or better outcome. I want to use an analogy, maybe some of the listeners will know about what a venture capital fund is. Effectively what that is, is you take a bunch of money, you pool a bunch of money and you may invest in. I’ll use technology companies in Silicon Valley for example.  Venture capital firm will take a pooled amount of investor money and they'll find 10 good ideas in the Silicon Valley.  

Evan Neufeld: Think of this like shark tank or Dragon's den  

Steven Guenther: Almost.  So you've got 10 ideas on Dragon's den, but you know, this would be outside of the reality TV world. They know that a bunch of those ideas are going to fail. But they also know that one or two of them may do really well, like a thousand percent on their money. And the other ones may go to nothing. 

What they're doing there is they're taking on risk in the sense of they're investing in a bunch of ideas that in all likelihood will fail, but with the potential for a huge, huge winner within that group of 10. So that's a way of thinking about risk in a sense that they know there is always the chance for failure and they may even expect it, but with high risk also comes high reward.  They might pick the next Microsoft of that 10 group. In which case, the gain from that will outpace the eight or nine losses that went to zero in that same time period.  

Evan Neufeld: They're not investing assuming that every single one of those is going to be a home run. That's just the price of it.  So, how do we understand risk in our own portfolios? Is there a way to know that, like we talked about that standard deviation thing, like we can actually find a number.  But in my mind, when you're looking at your own portfolio and assessing your risk, the easiest way to do that is to measure your own feelings when the market moves. If the market is going up and you're having the best day of your life and then market goes down you're having the worst day of your life. You might not have a very high-risk tolerance necessarily. Would you agree with that?  

Steven Guenther: Yeah. Your emotions play into a lot of your decision-making naturally. We'd like to think we're all rational, but naturally emotions have a component in any decision we make.  And with the feelings that you have around market movements, give you an idea of how sensitive you are let's say to risk. Part of it is a risk capacity component and the other part is a risk psychology component because someone who is maybe fairly indebted,doesn't have a particularly stable income stream from their job. 

Evan Neufeld: You might need the income sooner than later.  

Steven Guenther: Yeah. You have a variety of factors. And so that person from a risk capacity standpoint, doesn't have the financial stability to be able to accept higher levels of risk, for example. But I think what you're getting is the risk psychology component, which is what about the emotion that you feel surrounding ups and downs in the market or making financial decisions and your demeanor when it comes to losses versus gains. And naturally, most people have some level of what's called loss aversion where we, we feel losses at a higher rate then we feel gains. So if you lose $5 in a bet, it feels worse than how good it feels when you win that $5 bet because you've lost something. 

Risk tolerance is kind of a sensitivity to that, those losses. So the more sensitive you are to losses or to let's say risk in general, the lower risk tolerance, we'd say you have. We have to kind of pair risk tolerance as a two-parter. Do you have the capacity structurally in your finances? And then secondly, what's the mental, the emotional, the psychological components that make up how you feel about changes in prices, changes in the value of your investments over a number of different market cycles. 

Evan Neufeld: There's another way to look at risk too. There's a number of factors that you can control when it comes to risk, like where you're investing and that'll be next week's episode here.  But there's also things that are completely out of your control and you could feel comfortable about those different things differently. 

I have an author, Morgan Housel that I really enjoy ,stay with me here this is a long sentence, but his view on risk is that it is things that can happen in the world that are outside of your control that have a bigger influence on outcomes than anything you did intentionally. What do you think about that? 

Steven Guenther: It's a mouthful, but I believe it's true in its essence.  

Evan Neufeld: Here's another one for you that's a little bit simpler from Carl Richards. He says risk is what's left over after you think you've thought of everything else.  

Steven Guenther: So the unknown, it's uncertainty exists naturally. What risk is, that's a synonym for risk and uncertainty creates stress emotionally in any decision that we make. And certainly, that applies to any type of investment investing that you're doing or any decision-making. But the important part is to understand yourself and understand your position so that the decisions you make weigh risk in its appropriate way.  It's not playing into greed where you take on too much risk in a given decision. But when you come into investing especially and it's not playing on fear either where you're not taking enough risk to meet your set objectives. That's where you have to blend the objective with the subjective. When it comes to decision making. 

Evan Neufeld: What a good place to end there. That's perfect. So Steven, to invest smarter, you have to understand what risks are present in your portfolio and how you're going to react to them at any given time. Thanks so much for joining me today.  

Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes. 

This podcast is intended to be educational in nature, and you should always consult your financial, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes. Evan Neufeld is a Qualified Associate Financial Planner and registered investment fund advisor.  Mutual funds are provided through Sterling Mutuals Inc.