CouplePeople quickly associate the words “risk” and ‘risky” when they start thinking about investing. By nature, no one likes risk. When queried, we tend to describe our investing attitude by a short phrase, like “I am conservative”. That translates to say: I don’t like risk. Some respond by making their investing strategy “risk-free”, which may mean they park it under the pillow or they buy term deposits and GICs. At the opposite end of risk, some spend their investing lives chasing the “Last Chance Mining” big strike. Books on investing address risk and usually cover a conventional list. We aspire here to identify a broader and deeper list of risks.


The GIC lovers fail to understand that, in buying GICs, they have preserved their capital from the vagaries of the stock market – but only in NOMINAL terms, not in REAL terms. The difference between those two is INFLATION. European grandparents and South American parents have experienced hyper-inflation in their lives, so they appreciate the risk of ignoring inflation. North American parents have experienced double digit inflation in their lives, as well. For the past several years, Western economies have been managing inflation. In Canada, the inflation rate has floated around 2% for 8 years. That’s a small number, so we tend to ignore it. Mathematicians refer to the Law of Large Numbers. There is no Law of Small Numbers, but if there was, it would refer to 2% inflation over many years. If you are age 50, for instance, and your cost of living today is, say, $75,000, that same basket of goods will double to $150,000 by the time you turn age 85. While you are working, your earned income tends to increase (ie you get a pay raise!) to stay abreast of inflation. When you retire, your capital must pay the bills. If your nominal capital is not growing by inflation, then your real capital is declining. The risk here is that if your investing strategy does not address inflation, your real income from GICs will not keep up.

This problem exacerbates if that low GIC interest is earned in a taxable account. The combination of inflation plus taxes applied to a low interest return actually can mean a negative real return! Now you really are falling behind!

Tsunami effect

Your portfolio asset allocation strategy between fixed income and equities largely defines your exposure to stock market collapses. The conundrum is that investors today are loath to sign up for 1 ½% returns on their fixed income. The risk here is that an economic tsunami will severely punish a high equity-based portfolio….likely both at the moment of the collapse and also in the time interval to recovery. Today, this requires a shift in mindset as to the purpose of that fixed income. For the portfolio as a whole, you need to be concerned about long-term return on capital – that’s the long term compound rate of return. But, today, you need to focus the purpose of your fixed income as being return of capital, not return on capital. That mitigates the time interval to recovery from a market collapse.


Everyone understands the word, but it’s another matter to execute it in a portfolio. There are so many layers to proper diversification. The first layer is the asset allocation strategy between fixed income and equities. But that’s only the bare start. The second layer is deployment of equity capital around the world. On the equity side, we see many outside portfolios that invest solely in the Canadian stock market. As Canada counts for roughly 4% of the world’s economic activity, this leaves the other 96% off the table. The third layer is deployment of equity capital across businesses engaged in diverse pursuits…we refer to these as “sectors”. The fourth layer is spreading your equity capital across many holdings. We recently saw a portfolio that the investor described as “conservative”, which violated all of these. It held only Canadian equities and the entire equity portfolio pinned its hopes on a total of nine Canadian stocks: 47% of that was entrusted in three of Canada’s banks, 15% in one telecommunication company, 24% in real estate and 14% in one utility.

Foreign exchange

If you have addressed the second layer above by placing your investing funds out around the globe, then you do add another risk component: foreign exchange. Your return on holding a foreign security has two parts: the domestic return on the security +/- the movement of the Canadian dollar against that currency. In any given short run (like 2015), foreign exchange can have a HUGE impact on foreign investing returns. For instance, the annual return to July 31/2015 for the USD TIPS ETF was 17.98% with the exchange gain and -1.44% without.

If the investor response to that is to “stay in Canada” in order to avoid the exchange risk, then the risk shifts back to Canadian geography and sectoral weightings (discussed above). If the long term is the focus, then exchange movements tend to mitigate. That said, “bad start” is another phenomenon to be wary of: buying US$ today at 70 cents may promise an “ouch” in the future if the Canadian dollar recovers significantly.

Another aspect of exchange risk which isn’t thought about happens on Retail Street. Our imported goods are more expensive now at 70 cent dollars. “Exporting” our vacations out of Canada also gets more expensive, particularly if those trips are six month snowbird winters where you are living in US$. If your portfolio holds foreign investments, and ergo implicitly foreign currencies, then you are winning back some of that hurt by way of US currency gains when buying US goods and vacations. If you steadfastly remain a Canada-only investor, you are not.

Stock options at work

Your employer may offer (and possibly incent you to) stock purchase plans. Participation and management of such plans is important. Employer contributions to such plans may justify participating, but you need to be wary of building too large a financial position in your employer’s stock (eg above, like having 47% of your equity wealth in three Canadian banks). We have seen company stock plans go badly as often as they have worked out well. Also, you possibly are violating diversification here – the diversification of your labour and your capital! The risk here is that adverse conditions with your employer may effect your earned income stream and your stock value!

Tax management

This starts with fundamental principles of tax-smart investing, which we have written on extensively in our Library. The risk here is compromising your after-tax long term rate-of-return. In brief, tax-smart investing refers to the practice of understanding the taxation of the different kinds of income that a portfolio produces (interest, foreign/Canadian dividends and capital gains/losses) and then understanding how each investing account – TFSA, RRSP/RRIF (referred to as “sheltered accounts”) and non-sheltered account – is treated for those. Thus, the portfolio is built across those three accounts to achieve tax-smart investing, which increases the after-tax rate of return.

However, another level of taxation applies here, too. We might call this “The Law of Large Gains”. We have seen mature portfolios which have observed the buy-and-hold strategy across the years. The portfolio may be blessed that certain holdings significantly have increased in value in a taxable account. The risk here is that the investor is reluctant to sell the holding down and expose the tax liability, instead exposing the holding to losing some of its gain.Don’t let the tax tail wag the investing dog” may be the appropriate response. If the holdings are in tax-sheltered accounts, TFSAs and RRSP/RRIFs, then the tax problem is non-existent.

Taking profits

The example above has other aspects to it as well. Our Annual Report to clients tracks the appreciation in the portfolio in TWO categories – realized and unrealized – and we are mindful of their relative proportions. The latter simply means that the security has been held throughout the period and has gone up…on paper. Buy-and-hold is a mantra we read in investment publications. But what does this mean? We tend to interpret that it means, for instance, buying Apple stock and never selling it. But this strategy needs to be re-interpreted to mean holding the overall equity position, not the specific stock holding. The management of a) periodically rebalancing to the overall asset allocation plan and b) responding to movements in the industry sector proportions addresses this risk.

A client once told us: “You never lose money taking profits”! Well…sort of! The risk here is reinvestment risk: the risk that the profit you just gained could be given away with a loss on the next thing you buy! Your hero status in selling a winner can change into being a goat because the next purchase is a loser. One key here is to focus on the mantra: The portfolio is the thing, more than the individual things in it. Accordingly, the metric that counts the most is the long term compound return of the portfolio, not what you just made on selling Apple shares.

This subject inevitably segues into the matter of market timing if your profit-taking was market-focused, rather than individual stock-focused, because you believed that the market was going to collapse. There is endless research on this topic, supporting whichever side of the coin one chooses to believe. For sure, it must be recognized that market timing requires getting it right TWICE – once getting out and then later getting back in. Longitudinal data on timing shows, for instance, that being ”out” for the five biggest market days in the 20 years from 1994 to 2014 would have meant that an initial investment of $100,000 would have grown to approx. $280,000, vs approx. $420,000 if the investor had simply stayed in.

Managing cash calls

If you are at a stage where you require regular draws from your portfolio to fund life, then you must manage the risk of bad timing in converting investments into cash to fund those calls. The stock market can get cranky quickly, and fall 30% in a very short time. You don’t want to be cornered into selling beaten-down stocks to buy this month’s groceries. There are several strategies to insulate this. One is to keep a year’s cash calls IN CASH. Another is to fund cash calls by pre-mature selling of bonds, which typically don’t get beat up when the stock market does. Another is to manage your 1-2 years of cash calls with a periodic series of maturing bonds.


 Managing the Ages and Stages

Managing future cash calls has another time dimension, too….the longer term. The day after you receive your final paycheque, your investments take over as the prime bread-winner. If you were not looking out in advance to that day, your portfolio may not be suitably constructed to send your future pension pay cheques. In other words, you still may have a heavy growth orientation with stocks. The risk here is that your stock portfolio may get pounded right when you need to liquidate part of it. You need to prepare for this well in advance – not just 1 or 2 years – by shifting investment holdings to be able to produce that monthly pay-cheque without exposure to stock market vagaries. Quantify at least the first five years in the future when you will be calling on your portfolio. This also is relevant for RESP liquidations.

Managing ignorance

Sound portfolio management is complex: there are SO MANY layers to it. We are all familiar with Donald Rumsfeld’s famous quote: “There are also unknown unknowns – the ones we don’t know we don’t know”. This applies to managing money..and it applies to all of us. The risk here, of course, is making our investing decisions in a vacuum of unknown unknowns. The aspirant solution is relentness pursuit of knowledge to shrink those “unknowns”.