Managing Risk Successfully and Effectively
You can't avoid risk, so your best bet is to learn to manage it effectively. That means understanding the nature of risk and the tools you can use to manage and limit it.
A variety of risks can be managed, or protected against, with insurance. For example, we insure our homes for fire and our cars for theft or damage. We protect our estates with life insurance, which can be used to pay taxes at death and provide sufficient fund for heirs.
Managing investment risk becomes extremely important if you are retired or anticipate retiring soon. That's because investments either inside or outside registered plans such as RRSPs will likely provide most of your retirement income. You want these to grow, but at the same time you want to protect what you have accumulated so far. To be successful, it's vital to understand specific types of risk associated with specific investments.
Interest rate risk. This is the risk you run if you lock into longer-term interest-bearing investments, such as bonds or GICs, and then see interest rates rise. If you hadn't locked in, you would be able to take advantage of the higher rates. The best way to manage interest rate risk is to invest in a variety of interest-bearing securities with different maturity dates, so that you always have a security maturing and can take advantage of interest rate swings.
Inflation risk. When you are retired, this is a risk you must avoid. You'll run into it if you invest in very secure, low-return investments, only to find that the inflation rate is higher than your after-tax return of the investments. Inflation risk is also a factor when locking in longer-term interest rates and the inflation rate subsequently jumps.
Again the solution is to diversify. But you might also consider taking on more risk. It's usually not difficult to find relatively secure investments that generate an after-tax return that betters the inflation rate.
Liquidity risk. Liquidity is a meaure of how easy it is to sell an investment. Investments that are easy to sell can produce lower returns than illiquid investments. To manage your risk in this situation, it is best to devote only a portion of your investment portfolio to illiquid investments.
Currency rate risk. If you travel a lot, or spend a few months down south when you are retired, limiting this type of risk is important. Watching our dollar drop against the American dollar hurts if you spend time in the United States but your money is invested in Canadian dollars. To limit currency rate risk, ensure that a sizeable portion of your inestments are donominated in U.S. dollars or the currency of the coutnry where you expect to spend a great deal of time.
Risk of uncertainty. All investments are subject to uncertainty. For instance, the company in which you invest may be badly managed or a competitor may come up with a better product and dominate the market. Dealing only with secure, financially stong companies helps limit your risk. Otherwise managing the risk of uncertainty is best left to experts. The solution for most investors is to let professionals manage your investments. You can accomplish this most easily by investing in mutual funds.
