I have written on previous occasions about what the real definition of risk should be when you are investing. Essentially we operate under a different definition of risk then the majority of the wealth management industry, who measure risk based on the volatility of an investment. I don't subscribe to this definition of risk mostly because I don't find it very useful. The past volatility does not equal future volatility.
But that isn't the only reason why we don't use volatility as a measure of risk. The other main reason why I don't think volatility is a good measure of risk is that risk is largely dependent on your own personal time horizon for the investment. So the risk of any particular investment is largely dependent on your own personal circumstances. Let me give you an example.
Risk as an Example: Berkshire Hathaway
Let's say you are an individual who is saving for a home and are looking to make that purchase within the next 2 years. With a personal goal like this, your time horizon is short, and volatility of your investment could matter a lot to you. If you invested in a share in a business like say Berkshire Hathaway, you might find that the market crashes right before you go to buy your home and withdraw your savings.
Berkshire Hathaway is a blue chip company but their stock still fluctuates a great deal in a year. The price is still down about 8% year to date, and was down a lot more just a couple of months ago. This would be very detrimental to you and your goal of buying a home, as you would be selling at a loss. If it got really bad, you may not even have enough money to purchase your home anymore. If you had put your down payment for your home in Berkshire Hathaway stock at the start of the year, you would not be very happy right now. In this case Berkshire Hathaway was a very risky investment.
Risk as an Example: Saving for Retirement
On the other hand, let's say you are a person in your 30s who is saving for retirement in 25 years. You don't plan on spending any of the money you've saved for at least until you retire, which gives you a 25 year time horizon. 25 years is a long time for an investment but a company like Berkshire Hathaway is a very strong business. It is very likely that it will generate positive returns over a longer period of time. There will be many ups and downs during that 25 years, but given the long time horizon, the volatility becomes almost meaningless. In this case Berkshire Hathaway is a very safe investment.
Many of our clients are at or near retirement. They may make the mistake of believing that their time horizon is very short because they are relying on their portfolio for their retirement income. However if you are in your 60s, that means your life expectancy is probably going to be at least another 25 years. Your time horizon on the majority of your investments is probably going to be very similar to that 30 year old who is saving for retirement.
Sure a portion of your portfolio should be in investments that have minimal volatility, and it is these investments which you will draw your income from. But a business like Berkshire Hathaway can be a great investment for a person who is retired, and depending on your situation, you may even want to have the vast majority of your investments in stocks like Berkshire Hathaway. You don't have to take my word for it.
Shareholder's Meeting Clip
Here's a clip from Berkshire Hathaway's 1994 Shareholder's meeting where Warren Buffett gives his views on this exact topic. As you can see his view (and our view) is quite a bit different then the conventional view of risk. At about 1:48:30, Charlie Munger gives a much more candid appraisal of modern financial theories on risk. Incidentally, this can also work in reverse.
Some investments which are often rated 'low risk' based on their volatility can often become very risky if they are held over a longer time horizon. A 30 year government of Canada bond which yields approximately 1% might be rated as a low risk or even risk-free investment, because the Government can always issue new money to cover debts they owe. So it is virtually impossible to lose money on your principal IF you hold the bond to maturity.
However, the problem is that losses can still occur as a result of inflation. I would view a 30 year bond being issued today at 1% interest yield as a VERY risky investment, because of my opinion that inflation will exceed 1% annually over the next 30 years. If inflation exceeds the interest earned then I would be guaranteed to lose money, after inflation. This is far from low risk in my opinion.
So as you can see, how risky an investment is often depends on your own personal circumstances and is not just a factor of the investment itself. Anytime you see a risk rating for an investment, you should remember this, as the risk rating may not be very suitable for your own personal situation. You should always discuss the specific risks of an investment with your advisor, and the risk of your investments should only be assessed in conjunction with your own financial goals and time horizon.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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