The Money Management Newsletter: Managing Money
Using graphs to explain risk

By the Money Management Editor
Money Management Newsletter, December 2004

We’ve talked about risk before, and how best to understand its effect. We know that the risks you undertake will be as different as you are individually. We also know the risks in investing ultimately mean the possible loss of capital in the pursuit capital growth or income.

We’ve provided 13 definitions for the different types of risk in our on-site financial glossary. Provided are Adjusted assets, Company Risk, Credit Risk, Currency risk, Economic Risk, Industry Risk, Inflation Risk, Interest Rate Risk, Liquidity Risk, Market Risk, Political Risk, and Reinvestments.

Within the context of investing in the markets, we see two other risk factors emerge. First is Sector Risk. As you’ll see in the sector risk chart below, the sectors are measures of how certain “Sectors" such as Health care or Industrals within the market(s) have performed against other sectors.

SECTOR RISK

Sector performance is affected by numerous factors, making it highly unpredictable Wild swings can occur over short periods, as seen in IT and Health Care between Sept. 2002 and Sept. 2003 Sector bets can be risky and underscore the need for diversification across sectors

Shortfall Risk is where the capital and anticipated income are both depleted at certain rates of return are factored in. The thing here is to balance the risk of capital appreciation and income against the longevity of both. The charts shows from age 55 with $500,000 invested at 4% return, and implementing a systematic withdrawal plan of $45,000 per year. The investment depletes at age 69. The illustration also shows an 8% return thus providing the investment with enough income to last until age 83. To generate the higher income the investor has to understand and measure the higher risk in relation to the higher return.

SHORTFALL RISK

50% of Canadians plan to use personal investment savings to fund retirement Investing too conservatively may result in premature depletion of funds Balancing risk with the need for income over an extended timeframe is essential

Coming to terms with the complex issue of investment risk doesn’t come easy. To help you we’ve included a few more pictorial charts dealing with Market, Inflation and reinvestment risk.

INFLATION RISK

Inflation erodes purchasing power so investors must realize the impact of saving in today's dollars and spending in tommorow's The effect of various levels of inflation on $10,000 is dramatic Like shortfall risk, investing too conservatively may have serious financial consequences down the road

REINVESTMENT RISK

On renewal of a 5-year GIC, investors face the risk that the current rate of return will be lower than that paid on their original investment Over the 34-year timeframe shown, the difference between the initial and actual total return was 214% A laddered approach or purchasing a fixed-income mutual fund can help mitigate this type of risk

MARKET RISK

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Best Emerging Market Equities 82.1% Foreign Equities 14.2% U.S. Equities 33.8% Canadian Equities 28.4% U.S. Equities 39.2% U.S. Equities 38.0% Emerging Market Equities 57.2% Canadian Bonds 10.3% U.S. Small Caps 8.9% Canadian Bonds 8.7% Worst U.S. Equities 14.7% Canadian Small Caps -9.2% Emerging Market Equities -7.8% Emerging Market Equities 6.6% Emerging Market Equities -7.7% Canadian Small Caps -21.5% Canadian Bonds -1.1% Emerging Market Equities -28.2% Foreign Equities -16.5% U.S. Equities -22.9% Indicies: total return, C$ Foreign Equities: MSCI EAFE index Global Equities: MSCI World index Emerging Market Equities: MSCI Emerging Markets Free index U.S. Equities: S&P 500 index U.S. Small Cap: Russell 2000 index Canadian Equities: S&P/TSX composite index Canadian Small Cap: Nesbitt Burns Small Cap index Canadian Bonds: RBC CM Canadian Bond Market Source: FMR Co., BMO Nesbitt Burns

Markets fall in and out of favour frequently and without warning Emerging markets and U.S. equities have bounced between the best and worst performing sectors over the past 10 years Diversification is key to avoiding overexposure to any one market

Charts courtesy Fidelity Investments.

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