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Striking A Balance Between Risk And Reward

I read this story about a couple planning their wedding – let’s call them Carl and Vanessa.

Vanessa wanted the ceremony to be held in a park next to a lake, but it would be several kilometres from town. The problem, practical Carl said, was there were no buildings in the vicinity should the weather turn stormy – after all, it was common for violent thunderstorms or hail to occur at that time of year.

Carl suggested that a good site would be his Grandmother’s gorgeously landscaped garden. And, if necessary, the guests could easily run into her large historic home to avoid being struck by lightning or pelted by hail. After much discussion, they did agree on this compromise. The wedding was beautiful, and all had a wonderful time.

As it turned out, the weather was warm and sunny – not a cloud in sight – a fact that Vanessa occasionally mentions to Carl, with some regret that it wasn’t held in the charming lakeside setting.

This story illustrates the importance of finding an acceptable balance of risk and reward. Each choice will have a consequence. When it comes to your money, the key is knowing what that acceptable risk is to you.

Investment Risk and Reward

Take a look at this chart of stock returns for the past thirty years.

Investment Risk and Reward

You can clearly see that the biggest reward came from U.S. stocks, but that also presented the biggest losses. Look at the roller-coaster ride of Canadian stocks. That’s why investors choose the green line – the balanced portfolio – which gave a comparable return to Canadian stocks over this time period without the same stomach-churning drops.

The most common ratio is 40% fixed income and 60% of a diverse combination of Canadian, US and foreign equities which provides a buffer when the stock market takes a dive and lowers your overall risk.

This shows investors are getting pretty savvy about their long-term investing strategy, but not so much for short term goals.

Safety of principal vs. potential rewards

I hear comments all the time from investors who don’t want to keep emergency funds, or savings for short-term goals in accounts that pay next to nothing when they have a chance of receiving double digit returns by holding equities.

A common retirement strategy is to hold several years worth of cash/cash equivalents for immediate cash flow needs and to ride out any market volatility when people are in the decumulation stage. Recently, financial writers have derided this strategy, stating that holding large amounts of cash can cause a significant drag on returns and make your portfolio non-sustainable in the long term.

So, what’s more important to you in these cases – safety of your principal when you need it, or the hope of higher potential rewards?

Revise your thinking

Instead of bemoaning the hypothetical returns you could be missing, you need to think of your cash savings as the equivalent to an insurance policy.

Like most of us, I have a home insurance policy. For over thirty years I resented paying that annual premium. But, when my basement flooded one year I was very glad I had insurance. It must have cost thousands of dollars to clean up the mess, tear out and replace the drywall and flooring in our 1500 square foot space, as well as replace our furniture and other belongings.

Without insurance that would have come out of our pocket, and it’s very likely we would not have been able to afford to do it all.

Final thoughts

Risk of losses is very real. We need to take the necessary steps to reduce our risks to an acceptable and comfortable level, especially with our investments. When your time horizon is short, wouldn’t you rather (wistfully) say, “I could have had a 12% return if this money was in the stock market”, instead of, “I don’t know what I’m going to do. I lost half the money I need right now for my purchase/living expenses.”

I know what I would rather say.

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5 Comments

  1. The Curious Frugal on April 18, 2018 at 2:47 pm

    It’s interesting how individual this balance will be too. My husband and I are pretty compatible financially but he’s definitely more risk adverse than I am. Even though we’re both frugal and careful and not very spendy and very similar in those ways, my risk tolerance is higher. I found this interesting to discover because we were so similar in so many other ways money-wise.

  2. James on April 18, 2018 at 4:13 pm

    Interesting article, I am recently retired and have all of my money invested (TFSA, RRSP, RIF and non registered) as I have a company pension that more than pays the bills. I had a great year last year but sure did not enjoy doing my taxes this year. The great returns from last year gave my various T3, T5 and T5008 forms that were a nightmare to figure out and when the dust settled everything was added onto my pension and I found myself in the wonderful position of for the first time in my life having to pay taxes instead of getting a refund. It was not a pleasant shock to come up with 16k on my balance owing, especially since I had already paid 15 K in taxes off my pension. All that to say this year I think I will move my non registered funds to GICs, taxes will be easier, risk will be non-existant and I will sleep better. I did enjoy the high returns from last year but this 2018 first quarter has given me the jitters. I am retired and want to spend money now and not have it in my 90s.

  3. Dividend Earner on April 18, 2018 at 8:26 pm

    I actually plan on having this current year and the following year in cash to avoid the necessity of withdrawing during a critical drop. I have modeled the impact on my portfolio already to find out what the best amount I need should be. The result is to save some more, thus working a little longer.

    I am just about to put that to the test when withdrawing for RESP 🙂 – although on a smaller scale.

  4. Bernz JP on April 19, 2018 at 12:15 pm

    I believed in making decisions after a risk/reward calculation especially when it comes to investing in the stock market. By doing so, we are limiting our risk. You can calculate the risk and reward through extensive research and by establishing a target price. Once the shares of stock are owned, and you find yourself in a situation when the risk and reward become unfavorable, do not be afraid to sell the stock. Like you said revise our thinking.

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