Synopsis: Risk is such an interesting word. It’s not neutral, in fact our minds automatically recoil at the mention of it. So how and why do we use it in the financial industry? Did we always use it? Are there additional concerns to be considered when making financial decisions? This article explores those questions.
Is Risk ALWAYS a Bad Thing?
As our species developed, we were concerned about survival, since the world was not an overly friendly place. Something that might want to kill me might be lurking around any corner. Our minds developed a critical skill - thinking to keep us alive! Avoiding potential danger was a critical survival skill, and those who didn't possess that ability usually died before procreating. It's absolutely normal to be risk averse!
But, what is risk?
My personal definition of risk is anything that raises the possibility of living a life of less quality than I desire. Examples of risks would include anything which might kill me, cause physical or emotional injuries, or force me to postpone doing what I want to do at the time when I want to do it with the people with whom I want to do it.
Risk occurs because there's something unknown to me - some possibility for which I don't have the skills to foretell the outcome. Knowing more about the outcome always reduces the risk!
Allow me to give an example from my life. I spent a lot of time (and considerable money, too!) in self-improvement courses. During these courses I have walked across burning coal embers 3 times. The first time I was near petrified, but managed to follow the lead of others who were doing it. The second time, I still listened intently to the instructions on how to walk across the coals which is the secret to not getting burned, but I was fine to lead my group across the coals. The third time, I didn't pay any real attention during the instructions presentation. Why? because I knew the outcome and the process of achieving that outcome.
Knowledge is the KEY!
What about Financial Risk?
Here's where some people make a few incorrect assumptions. Financial Risk as it is currently used implies the variability of returns of an investment. But is that really what I care about?
Turns out the answer is likely to be a solid "NO!" for most people
What I really care about is how much I can buy with the money I receive back from this investment at the time I get it back. For example, a recent ratehub.com analysis said the following:
"Now let’s see how GIC rates have fared historically. First, we pulled data from the Bank of Canada website, to show the nominal returns for 1, 3 and 5-year GICs going back to 2005. The average nominal returns from 2005-2014 were between 1.40-2.28%. If we compare that to the average consumer price index, which was 1.81% from 2005-2014, the average real return was between -0.41% to 0.47%."
Let's use an example to make this clear. Let's say at the start of this period we invested $100,000 in one year GICs and rolled those GICs over into another 1 year GIC at the end of each year. These GICs would have averaged 1.4% over the ten year period, meaning that at the end of this decade, I would get back $115,029. Looks good, at least so far!
But let's consider taxes and inflation. First, the taxes are easier. If we assume the lowest current tax rate of 20.1% and no provincial income taxes, then the federal government will want %20.1% of our gain, or $3,021, leaving us with $112,008. And, at an average inflation rate of 1.81%, what we could have bought for our initial $100,000 now will cost $119,647. We would have to pull an additional $7,639 out of our wallets to buy what we could have bought with our initial capital 10 years ago!
It's important to know that there's no financial risk involved in this calculation. The returns were guaranteed. But is the result meeting our desire to grow our wealth? Absolutely not! There's a large amount of lifestyle risk associated with using this guaranteed return strategy for periods longer than for which it makes sense!
We MUST be willing to take on some element of financial risk to avoid the high lifestyle risk associated with long-term use of guaranteed investments!