Almost all investors want their investments to be low-risk. In industry jargon, risk refers to volatility. Volatility is the history of a security’s or a market’s gains and losses. As investment advertisements state, past experience is no assurance of future performance. However, past experience does often indicate the degree to which the value of the security and the market will fluctuate.
The Beta Factor
To an investment industry professional, if something rises quickly, it can be expected to descend just as quickly. The industry term “beta” compares the value changes of the security to the market generally. A low beta means that the security value will change less than the market changes, and is therefore of lower risk. However, the stock market itself can be very volatile, i.e. risky. We have seen increases of 100% and decreases of 50% (which amount to the same number of dollar) in a very short period of time. And there is no way of forecasting when, how much or for what length of time the market will rise or fall.
Would you think differently if there is a one-in-three chance of a 10% loss, as opposed to a one-in-10 chance of a 20% loss? How about a one-in-20 chance of a 50% loss? Twice since the year 2000, we have seen drops of almost 50% in a two-year period. In reality, what happened in 2008 was not that uncommon. Some industry opinions suggest higher volatility is here to stay. So, what will 2012 bring?
Appropriate Risk
The US and Canadian stock markets generally increase and decrease by more than 10 per cent within any given year. If you are not prepared to accept a 10% loss in a one-year period, you should not allocate most of your investments to the stock market. And, even if you are prepared to accept a risk of loss in the range of 10% in one year, you should be advised that the next year may see further declines. Just as a decline in the market doesn’t guarantee a subsequent rise, nor does it guarantee a halt to the decline as time passes.
Understanding the Market(s)
The “market” is actually made up of a number of markets. During the course of any given market week, investors buy and sell more bonds than they do stocks. They also buy and sell more currency and more commodities. Bonds, currencies, commodities and stocks each represents a different market, with a different risk profile. Also, within the stock market as well as the bond market, there are different economies and governments, different sizes of company, and different sectors of the economy, each of which can be considered a market in its own right.
Risk and Your Investment Policy Statement (IPS)
Typically, people do not invest to gamble. They invest to accomplish a purpose, most often to retire comfortably. What risk really means in that circumstance is that inappropriate investment choices may not accomplish that purpose. A professional financial advisor must try to establish reasonable goals with you and to allocate investments that will help you meet those goals, all of which should be reflected in your IPS. Should your financial circumstances change, your advisor must re-establish appropriate goals and investment allocations. This is best accomplished with regular communication between your advisor and you, and regular updates to your IPS.
Understanding Risk
When a financial advisor discusses risk with a client, the advisor must determine whether the client understands the true meaning of the word “risk” and of the levels of risk. Many investors do not know that meaning, and many advisors would be hard-pressed to explain it correctly. And, shockingly, many investment firms do not even have a standard definition of the term or the ranges for “high,” “medium” and “low” risk.
In the case of the discretionary financial advisor (one who is mandated by a client to make day-to-day investment decisions without consulting the client) the advisor has an obligation to keep all investment allocations within the risk expectations of the client. These expectations should be set out in the IPS only after the client provides instructions and gives informed consent, based on the advisor’s careful and complete explanation of the risks. An uninformed client cannot give informed consent.
If your financial advisor has not fully informed you of the risk of your investments, you have the right to complain to your provincial securities regulator and to retain legal counsel. For a free consultation, please complete and submit our online form.