What are the two main types of Risks when Investing?
Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street, investing, capital planning, or something else.
This content will examine two types of risk when it comes to investing.
Excerpts from the Book - Preserving Wealth - written by Jack Lumsden, MBA, CFP®
“There are basically two main types of risk: capital preservation risk and inflation risk.
Capital preservation risk is the risk that your capital is not there when you need it. Let’s say you were going to buy a new boat in a year, and the cost was $25,000. To make sure you had the $25,000 in a year, you would have to invest in conservative investments, such as a high interest savings account, so you’d have the $25,000. If you invested in equities/stocks, in a year you could have more than $25,000 or a lot less.
Inflation risk is basically making sure that your money grows over time as items get more expensive each year. Even inflation of 2% over twenty years, as in the prior example, can lead to costs increasing dramatically."
“Even if you’re close to retirement, you still need some growth in your portfolio, because peo¬ple today are living longer, and the longer you live, the greater the chance is that inflation will beat you. I’m sure you all want to live a long time, but you don’t want to outlive your supply of money, so your financial plans should be based on a project¬ed life span to your mid-nineties. That means Sally needs her money for the next sixty years, and Mark for another forty-two!”
Mark looked surprised and took a sip of his drink. “Wow, that is a long time. I wonder if I’ll still be water skiing then!”
Sally started to laugh and said, “You can barely water ski now! You only go once a year after a few brown pops!”
Uncle Wayne coughed to get our attention and continued. “So you all will need growth or equites in your portfolio to keep up with inflation. A globally diversified portfolio is made up of both bonds and stocks/equities from countries around the world, and the breakdown is determined by both your goals and your risk, or sleep at night, factor.”
“What specifically do you mean by goals and sleep at night factor?” asked Sally.
“Let me try to answer that,” Alice went on. “For short term goals, say when you will need the money in less than five years, you’ll want to use conservative or defensive investments like short term-bonds, GICs, or high interest savings accounts, so that the money is there when you need it.
“Longer term goals can be more difficult to plan for. For example, if you can attain your retirement income goals based on only investing in GICs and/or bonds, then the risk of your portfolio will be low, and it will not fluctuate much. Since your money growth is more consistent, you’re better able to sleep at night, because you really don’t need to worry too much about your portfolio declining in value."
“However, for many people, us included, to achieve our retirement income goals, we need higher returns than what bonds or GICs can provide … so we must invest in stocks. This is where the sleep at night factor comes in. The greater the allocation to stocks or equities, the greater the fluctuation—daily, monthly, and annually—of the portfolio returns and portfolio. This fluctuation of returns is called your risk level, or sleep at night factor. If you can’t sleep at night because your portfolio value changes too much, you may need more capital preservation type of investments in your portfolio; however, if you do this, you may not generate the returns required to achieve your goals. So how did I do, Uncle Wayne?”
For more information you can refer to Chapter 3, Protecting and Preserving Your Wealth from the book, Preserving Wealth: The Next Generation - The definitive guide to protecting, investing and transferring wealth by Jack Lumsden, MBA, CFP®
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