Why Risk is More Than a Feeling for Investors

The following article was first published by RBC Global Asset Management under the title, "How do you think about risk as an investor?”

From stocks to bonds, and everything in between – every investment comes with some level of risk. Risk refers to the possibility of your investments not performing in the way you expect them to. To some, that means losing money when the price of an investment changes. To others, it's seeing your investment lose purchasing power because of inflation. No matter what risk may look like to you, it will play an important role in your investment decisions. Before you start investing, it is helpful to ask yourself some questions about risk.

First, you will want to understand your tolerance for risk. For example:

• How comfortable would you be with market volatility?
• How might you react to seeing your investments drop in value?
• Are you someone who embraces investment risk because it opens the door to more opportunity, or are you more risk averse – and likely to lose sleep when the market loses ground?

How risk tolerance changes the way you invest

Risk tolerance relates to your willingness to take on risk to achieve your goals. It's based on your beliefs, your personality and your investment experience. Think of it as your mental and emotional ability to handle possible investment losses.

For example, if you are more comfortable with risk – you may choose investments that offer faster growth and higher potential returns – even if it means your holdings may lose value at times. If you're a risk-averse investor, the opposite is true. You would opt for investments that aim to 'defend' your investments against losses – even if it means you could potentially see lower returns.

How risk capacity changes the way you invest

Risk capacity is not based on your feelings about risk. It's not even based on any specific investment. Instead, it relates to how much risk you can afford to take. And that has to do with your financial situation, as well as your age and the time you have to invest.

It is important to ask yourself how potential losses would affect your ability to reach your financial goals. For example:

• Are you saving for your child's education? How many years before they finish high school? Will you have time to make up any losses if you take more risk as an investor?
• Are you close to retiring? How much have you saved? How will it affect your plans if your retirement fund drops five or 10 per cent in value before you retire?
• Is time on your side? Do you have many years to invest? Or will you need to take money out of your investment account soon?

Why time is an important consideration for risk capacity

The longer you have to invest, the more time you have to make up for any losses along the way. Over time, markets generally recover from losses. That's good news if you have a long-term goal you're saving for, such as retirement. This means you have a larger capacity to take on risk in your portfolio.

But, you may not be able to tolerate that level of day-to-day movement even if your financial situation and time horizon say you can. You might still opt for a lower-risk option that matches your tolerance.

The opposite is true if you have a shorter time to invest. Now let's say you have a nearer-term goal of buying a home in the next year. You now have less time to make up for any losses and so cannot afford to see a 12-per-cent drop in your investments, let alone an over 30-per-cent drop.

In this case, your risk capacity dictates that you may want to opt for more conservative, low-risk investments – even if you think you could handle the emotions that come with losses.

When making investment decisions, consider your overall financial picture, including the time you have to invest.