Risk: avoiding permanent loss

One very important concept in the field of finance is the relationship between risk and return.
Generally speaking, the higher the return you want, the more risk you must take because there is a higher probability of loss.
There are mathematical and statistical methods for calculating the risk of a specific investment and an investment portfolio, but we do not wish to describe those methods in detail.
Rather, we want to describe risks people should consider when evaluating their investment strategies and investment portfolios.
The most obvious investment risk is the risk of permanent loss – loss of principal.
Loss of principal occurs when you buy an investment and sell it for less than you bought it for. If you do not sell that investment and it is lower than what you bought it for, it is a paper loss and that loss is not realized (does not become permanent) until you actually sell it.
Ever since the unusually large market crash took place in 2008, many people want to talk about how they have losses in their portfolio and one of the first things I will ask them is if they have sold those investments and turned those paper losses into real losses.
This is an important principle because if the whole idea of investing is to make money, then losing money is what we want to avoid. We only want to realize those paper losses in specific situations.
Practically, this means avoiding certain types of investments. For example, we all know that certain penny stocks can double or triple in value within a very short period. However, many of those investments will drop to zero in value. Investors who wish to avoid permanent loss will stay clear of investments that have a high likelihood of becoming worthless.
The difference between a paper and an actual loss requires me to describe another element of risk that needs to be considered – volatility. When investment professionals speak of volatility, they are referring the range that an investment or an investment portfolio will fluctuate within, from the highest value to the lowest value without necessarily being sold.
Even though there is no actual loss in the investment, the fact that it can drop so much in value can cause you to feel very nervous and uneasy. For example, you may buy an investment for $10, but if it declines to $5 this paper loss can cause you to feel very uncomfortable and even scared. Now you face a decision. Should you sell the investment and permanently realize this loss which would be a loss of 50 per cent or should you continue to hold this investment and not sell it because you believe the investment will eventually be worth more than the price you initially paid for it?
This question is useful because it allows us to consider a number of key points. First of all, not all investments go up in value.
Poor investments can not only drop significantly in value, they can become worthless. Secondly, since one investment can become worthless, you can reduce the possibility of your total investment portfolio becoming worthless by having a number of investments within your portfolio. This practice is commonly referred to as the concept of diversification and it is intended to reduce investment specific risk.
If, by chance, the investment does become worthless or goes down significantly in price, it will not affect your investment portfolio to the same degree since you also have other investment holdings in your account.
Thirdly, you should have a certain amount of investments within your portfolio that are less risky than others. The process of holding different types of investments within your investment account is referred to as asset allocation.
For example, investments such as government bonds which are issued by the government of Canada are considered among the safest investments because the chance that the government will default is very low. If they are in danger of defaulting, they can raise taxes to meet their obligations.
While the methods listed above can lessen the risk of permanent loss, careful study and analysis of the investment opportunity before you make the investment is also required. To be able to successfully evaluate a potential investment requires certain skills which can be learned or as most people prefer to do, left in the hands of a capable professional. These skills can be defined as ‘financial literacy’ and require an understanding of how capital markets work, the ability to analyze financial statements and also the technology to act upon the results of the analysis.
I wish there would be a magic formula to direct you to so that you will never experience a permanent, investment loss, but this is not the reality. Even the most successful investors in history like Warren Buffett or Peter Lynch lost money on certain investments.
Since we know that every investor will experience loss at some point what is the point of this article? The point of this article is that various investment risks, including the risk of permanent loss, can be managed by using some of the concepts and habits listed above.
In the same way that you drive on the right side of the road and buckle your seatbelt to reduce the risk of a serious accident on the road, you can also reduce the risk of irrecoverable loss in your investment account by avoiding opportunities that have a high probability of becoming worthless, proper diversification, appropriate asset allocation and careful study.
In life as in investing, risk cannot be completely eliminated – risk must be managed and reduced by following certain principles, actions and habits.
This article is supplied by Gordon Keesic, a Lac Seul band member and an Investment Advisor with RBC Dominion Securities Inc. Member CIPF. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article.