Risk is inherent in all investments, to varying degrees. Stocks, bonds, mutual funds and exchange-traded funds can lose value due to a specific event related to the underlying company or to negative economic and market sentiment. Even so-called “safe investments”, such as GICs or money market funds, have inflation risk – the potential loss of purchasing power.
The reward for taking on market risk is the prospect of greater investment return. If you have a financial goal with a long time horizon, you are likely to have a better chance of success by carefully investing in asset categories with greater risk, such as stocks or bonds, rather than restricting your investments to low-risk asset classes. However, depending on one’s time horizon, investing solely in liquid cash investments may be appropriate for short-term financial goals.
By including various asset classes with diverse risk-and-return characteristics that behave differently under various market conditions, an investor can help buffer the downside risk of their portfolio. History has demonstrated that the returns of stocks, bonds, and cash have not moved up and down at the same time or by the same proportion. These general classifications can further be diversified by credit quality, liquidity and geography. Market conditions that cause one asset class to perform often imply that another asset category will perform less well. Moreover, the volatility characteristics of each asset class will not move in tandem. Diversifying by asset class reduces the risk to the portfolio and ensures that the portfolio’s overall investment returns will have a smoother return pattern. Frequently rebalancing the portfolio back to its original allocation targets is important in solidifying gains and managing risk.
Taking on investment risk within an asset allocation framework is essential to meeting your long-term financial goals. Taking too little of a risk could cause one to fall short of meeting their goals. Taking too much risk might cause one to abandon an investment strategy during market downturns, and as such, locking in the losses.
The evaluation of a client’s risk-return profile is not only an important component of the KFA discovery process, but also, part of an ongoing dialogue in the client-advisor relationship. In addition to internally developed risk profiling tools, KFA utilizes a third-party behavioural finance risk assessment process as an additional resource. After fully addressing our client’s risk profile, an appropriate asset mix would then be recommended.