Do risk free investments really exist?
Over the past 19 years, I have been asked such things as “What is the least risky thing I can invest in?” or “I want a great return but I don’t want to lose money!” Nevermore so have people posed these types of questions than in the past 4 years. There are a lot of people who want to invest their money but do not want any risk or chance of losing money.
What is the risk?
Webster’s Dictionary defines Risk as a “chance of loss or injury; hazard; danger, peril. To expose to possible danger or loss; to take the chance of.” Oxford Dictionary defines Volatile as “liable to change rapidly and unpredictably, especially for the worse.” I think the average investor doesn’t like the volatility that market investments bring. They want to protect what they have, get a nice return on their investments but to want smooth sailing along the way.
Inflation is the big evil
Inflation has more of a negative effect on your portfolio than your return. A 1% less rate of return has a minimal impact on your portfolio than a 1% increase in inflation. Inflation will eat up your money fast. When we invest we need to stay ahead of inflation so that you have buying power when you need that money.
There is no such thing as a risk-free investment
As far as I know, there are no risk-free investments. Every investment that you place your money into has risk and reward to it. There will be negatives and positives for every investment.
Let’s use the 2012 Andex Chart to compare returns and inflation and to keep things simple. If we look at the past 10 years, ending June 30, 2012, inflation over that period of time ran at an average of 2.0% so our goal is to earn more than 2% on our investments. Let’s compare GICs, Bonds, Canadian Equity and US Equity.
5 Year GICs earned an average of 2.7%. GICs are great because the capital is guaranteed and the end result is predictable. The typical drawbacks to GICs are the lack of inflation protection and that the interest you earn (outside of TFSAs and RRSPs) is fully taxable. Inflation risk is a big concern here.
DEX Long Bond Index of the past 10 years earned 9%. Long bonds have had fantastic returns over the past decade. Bonds have rewarded investors with higher returns but bonds carry interest rate risk. Bonds can experience negative returns if and when interest rates increase. You only need to go back to 1981 to find that this index generated a negative return of -15.9%. However, over the long haul, you have earned a healthy return.
S&P TSX Composite Index returned 7.6% over the same period. We don’t need to look too far to understand the risk of equities. In fact, 2001, 2002, 2008, and 2011 quickly come to mind. It’s been said many times that the reward of equities is higher potential returns. Unfortunately, equities are also risky because of the possibility of significant drops in the short term. This is called market risk. Despite the drops from the tech meltdown and financial crisis over the past decade, you have stayed ahead of inflation and taxes for a positive net return.
US Large Stock Total Return for the past 10 years was a dismal 1.2%. With all the bad news that has come out of the United States since 2008, you would have still ended on the positive over the past 10 years. Barely, but still on the plus side.
Diversification and risk
No matter where you put your money you will have risk. We battle inflation, interest, market and longevity risk (The risk of living too long). You cannot avoid risk. If you have a well-diversified portfolio with a certain percentage of each investment you minimize your overall volatility and smooth out your returns.
Do not get overweighted in any investment class. A diversified portfolio can withstand anything that the market throws at you.