Investing is one of the main ways your clients can grow wealth over time, but it always comes with risk. Markets move up and down, interest rates change, and personal circumstances shift with little warning. Managing investment risk is just as important as understanding potential returns.
In this article, Wealth Professional Canada sheds light on investment risk and how to manage it. We’ll also list the nine types of investment risk that can affect your clients’ portfolios and other valuable insights.
Investing always involves some level of uncertainty. When your clients buy stocks, bonds, mutual funds, or other assets, they’re hoping that those investments will grow and produce a return. At the same time, there is always a chance that the outcome will be different from what they expect. That gap between what is expected and what actually happens is where investment risk comes in.
Investment risk is the possibility that the return on an investment will be lower than expected or that your clients will lose some (or all) of the money they put in. This risk is present in almost every type of investment, even those that seem very stable. All investment vehicles carry different kinds and levels of risk that affect returns in various ways.
For financial advisors, managing investment risk is critical when you help your clients build portfolios. It’s not enough to look at potential returns on their own. You need to understand the types of risk involved and how they can affect performance over time. You should also see how those risks line up with your clients’ comfort level and investment objectives.
Risk and return are closely linked. In general, investments with higher potential returns also come with a higher chance of loss or volatility. If your clients want higher growth, they will need to accept a greater chance that their portfolio might drop in value along the way.
On the other hand, if they choose very low risk options, they might struggle to reach long term goals such as retirement income.
Explaining this trade-off in plain language can help your clients see that risk is not only about losing money. It’s also about the risk of not earning enough. A portfolio that feels very safe today might not keep up with inflation or provide the growth your clients need later in life.
Watch this video to know more:
Feel free to check out our Glossary page for more investment concepts and jargon.
At its core, investment risk is the chance that an investment will not behave the way that your clients expect. That can happen in different ways. For example:
Investment risk is not just about losing money in a downturn. It can also be about the danger of being too conservative and falling short of long-term goals.
There are many ways to classify investment risk, but nine categories are especially useful when you talk to your clients about portfolios. Each affects investments differently and can show up at different stages of your clients’ lives:
Market risk is the chance that investments will lose value because of events that affect the entire market. It is present in almost all portfolios.
There are three main forms of market risk that matter for your clients:
This applies to stocks or shares. Share prices change frequently as demand and supply shift. When markets fall, the value of common shares can drop quickly, even if the underlying business has not changed much in the short term.
This is especially relevant for bonds and other debt investments. When interest rates rise, existing bonds with lower coupons become less attractive and their market value falls. Real estate values can also be affected by shifting interest rates, since borrowing costs influence demand.
This affects foreign investments. If your clients hold assets in another currency, a movement in the exchange rate can change the value of those holdings once converted back to Canadian dollars.
Dollar-cost averaging can be used to mitigate bear market risk. Find out how in this article.
Horizon risk appears when your clients’ investment time frame becomes shorter than planned. A job loss, illness, or family emergency can force them to tap investments earlier than expected.
If this happens during a downturn, your clients might need to sell at depressed prices and lock in losses. Horizon risk is not only about market moves. It is about life events that change when money is needed.
Having an emergency fund in liquid, lower risk holdings can help. This gives your clients a buffer, so they are less likely to sell long-term investments at a bad time.
Inflation risk, or purchasing power risk, is the chance that investment returns will not keep up with rising prices. Over time, inflation erodes the value of money. The same dollar amount will buy fewer goods and services.
Some stocks have the potential to grow along with inflation over long periods, as companies raise prices or expand. However, inflation can also create uncertainty for businesses and markets, which can add volatility. Some companies might handle rising costs well, while others struggle.
Longevity risk is the chance that your clients will outlive their investments or savings. This risk grows more important as they near retirement and once they stop working.
A portfolio that looks large enough at age 65 might not be sufficient if your clients live much longer than expected. The same is true if they face higher medical costs or experience periods of weak returns.
Inflation risk and longevity risk often work together. If returns do not keep up with rising prices over many years, the real value of retirement savings shrinks, increasing the pressure later in life.
Concentration risk arises when too much of a portfolio is tied to a single investment, sector, or region. If that area performs poorly, the entire portfolio can suffer. Some examples include:
Liquidity risk is the chance that your clients will not be able to sell an investment, or access their money, when they need it without taking a price they do not like.
Highly traded securities, such as shares of large public companies, are usually easier to sell quickly. Other assets are more challenging.
If your clients face an unexpected cash need and hold mostly illiquid assets, they might be forced to sell at a discount. In some cases, such as certain exempt market products, there might be no ready market at all.
Planning for liquidity needs should be a part of managing investment risk, especially as clients approach retirement or have known spending goals.
Credit risk, sometimes called default risk, applies to bonds and other debt investments. It is the chance that the issuer will run into financial trouble and fail to pay interest on time or repay the principal at maturity.
Government bonds from stable issuers usually have lower credit risk than corporate or emerging market bonds. Within corporate debt, companies with stronger finances and higher credit ratings are generally safer than those with lower ratings.
Reinvestment risk appears when your clients have to put interest payments or matured principal back to work at a lower rate than before.
This type of investment risk matters most for income-focused strategies where regular cash flows are an important part of the plan. It is less of a concern if your clients intend to spend the interest or the principal at maturity rather than reinvesting it.
Foreign investment risk is the collection of extra risks that arise when your clients invest outside Canada. These include:
For example, a company in an emerging market might overstate profits due to weak oversight. Investors who rely on those numbers could face losses if the truth comes out.
Some of these risks can be reduced by choosing markets with stronger regulations or using international funds managed by experienced professionals. The underlying risks themselves still exist.
Want to find out what most people get wrong about investment risks? Watch this clip:
Aside from these types, you can also weigh investment risk using four metrics, and one of them is the Sharpe ratio. Learn all about it plus the other three measures when you read this article.
Cryptocurrencies are among the riskiest investments not just in Canada but globally. Prices can swing sharply, and the chance of fraud and hacking is high. Standard insurance or protection schemes usually do not apply either.
However, sticking only to very safe holdings, such as cash or low yielding bonds, is risky in a different sense. Inflation and longevity risk mean your clients might fall short of their long-term goals if returns stay too low.
In that way, taking too little risk can be just as damaging as taking too much.
Ongoing conversations about managing investment risk can help your clients stay invested during market downturns. When they see why their portfolio is built in a certain way, they are more likely to remain committed to the strategy. Advise them that without taking some risks, they’re unlikely to reach most of their long-term goals.
You can also show how practical steps such as research and analysis, diversification, asset allocation, and liquidity planning can help manage these risks. None of these approaches remove uncertainty, but together they can reduce the chance that one event or one poor decision will derail the plan.
In the end, managing investment risk effectively means more realistic expectations and steadier behaviour for your clients, especially during difficult markets.
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