“Investors love risk when stocks skyrocket, and hate it when they tank.” It is commonly accepted that there is risk involved in investing, but investors do not always know how to define it. In a recent white paper, PWL’s Raymond Kerzerho and Dan Bortolotti set out to help investors understand what risk is, and how it can be managed through a disciplined approach. In reality, the vast majority of investors choose to take risk management shortcuts like principal protected notes, hedge funds and guaranteed income products. These products “are often guilty of implying that you can achieve equity-like returns with bond or GIC-like risk,” which can be harmful to the long-term success of an investor.

Risk can be broken down into two broad categories: Economic risks, and Behavioural risks.

Economic risks are risks that investors have no control over, though they can be mitigated through thoughtful portfolio construction.  Economic risks include recessions, high inflation, and wars and political turmoil. The severe decline in stock prices during the Great Depression, negative bond returns after inflation from 1950-1980 in the US, and investors losing their assets due to the Russian revolution of 1917 are cited as respective examples for the economic risks that investors are exposed to.

Behavioural risks are in the investor’s control, but tend to be far more harmful than economic risks. “Even during periods of economic prosperity and booming markets, many investors experience low returns because of destructive behaviour.” Behavioural risks include concentration, market timing, and active trading. Investing in one company that is touted as the next Google, sitting in cash through a period when equities rise sharply, and doing analysis to identify mis-priced securities are given as respective examples of common behavioural mistakes.

There are steps that an investor can take to manage both economic and behavioural risks: Start with an appropriate asset mix – and stick to it, write an investment policy statement, keep your bonds safe, embrace only compensated risks, invest in entire asset classes, and review your portfolio. Following these guidelines positions even the most emotional investor to behave rationally.

Read the full PWL white paper, Managing Risk, here.