The Vault
Explaining how to manage investment risk
by Graham Barber

Every investment comes with risk. When we think of risk, we tend to focus on the possibility of losing money in the markets, either through investing in stocks or equity mutual funds.

But even investments that seem completely safe, such as savings accounts and GICs, also come with some risk - notably, that your savings may not keep pace with the cost of living.

If you're investing in an RSP, you need to stay well ahead of inflation and ensure that your money covers a long retirement. Historically, equity based investments have statistically outpaced inflation, even though they tend to be more volatile in the shorter term.

In other words, by taking on some risk in the short term, you increase your chances of success over the longer term. And the longer you hold your equity investments, the less volatile your returns will be.

As part of your diversified investment strategy, the key is to find the right amount of risk you're comfortable with (a good test is whether volatile markets keep you up at night), and then take advantage of the growth of the markets over time.

Understanding the different types of risk and how to manage them can help keep you on track.

Market risk

Also called market volatility, this type of risk is associated with investing in the stock market.

It includes any events that can depress the markets, such as war or political turmoil, or any events that can depress specific industries - such as the airline industry after 9/11. Market risk is notoriously difficult to predict.

Managing market risk

Diversification is the best way to protect against market risk. A diversified portfolio includes equity investments for their growth potential, fixed income (such as bonds and longerterm GICs) for their stability, and cash (such as money market funds and high-interest savings accounts) for their security and liquidity.

If the equity portion of your portfolio is declining, cash and bonds may take up their slack.

The assets mix that's right for you will depend on your goals, time horizon, and tolerance for risk.

Did you know? Your advisor has access tools that can help you determine an asset allocation mix that's right for your personal goals. Tap into the experts for advice that is tailored for your situation.

Company-specific risk

Also called "business risk", this type of risk refers to any event or trend that can hurt a company's profits, such as the failure of a major project or product, corporate scandal, increased competition, or changes in consumer habits.

Managing company risk

Mutual funds are a good way to manage companyspecific risk. Rather than buying the stock of one or two companies, a broadbased fund will hold a number of stocks for several different industries.

Inflation risk

The risk that rising prices for goods and services will erode the value of your savings. In Canada, inflation has been quite moderate for the past few years. However, over the long term the effects of inflation become evident.

A basket of goods and services - including food, housing, transportation, furniture and clothing - that cost you $100 in 1980 would set you back $239 today. Put another way, over the past 25 years, the average annual rate of inflation was 304%. If your savings were not earning at least that, you would be losing ground.

Managing the inflation risk

With their potential for long-term growth, equities and equity mutual funds have provided the best inflation protection over time.

Currency risk

Fluctuating currencies can affect the value of your global investments when they are converted back into Canadian dollars.

We saw this in the past few years, as the Canadian dollar rose against the U.S. dollar.

For instance, the U.S. equity markets advanced in 2005. But if you held a U.S. mutual fund you may have actually lost money when those investment gains were converted back into Canadian dollars.

Managing currency risk

Diversifying internationally can help reduce the currency risk. A global mutual fund, for instance, will invest in a number of countries and gain exposure to a basket of currencies. This can help protect your portfolio against currency fluctuations.

A long term perspective is also key as currency movements tend to be more moderate over time.

Interest-rate risk

The risk that rising interest rates will make your existing bonds and other fixed-income investments less valuable.

In other words, if you locked into a 5-year GIC paying 3% and rates then rose to 4%, you'd lose the opportunity for higher returns.

Managing interest-rate risk

A bond or GIC ladder is one way to manage this risk. For instance, instead of investing $5000 in one 5- year GIC, you could put $1000 in five GICs that mature over one, two, three, four and five years.

When each GIC matures, it can be rolled over into a new 5-year GIC at the going interest rate.

Are your RSP investments diversified? Do they match your goals and risk tolerance?

Speak to your advisor about how to get the most from your RSP.