Mr. Money goes to work, investing
This week’s article is inspired by the staff at Servus Credit Union who recently took my Mutual Funds in Canada course.
One of the students asked a very good question: Why do we really get paid to invest?
A simple answer is that we get paid to invest because when we invest we are taking risk.
Let’s take my imaginary friend, Mr. Money, who lives in Finance World. He regularly invests 10 per cent of his income towards his retirement.
In Finance World, the risks of investing for Mr. Money come from the volatility of investment asset prices. That is, the risk that his net worth will be lower due to a drop in the price of his investments.
Mr. Money gets paid to take risks that may be average in nature, in which case his returns would be average. However, if Mr. Money takes above-average risks, his returns will potentially be higher.
The higher the risk, the higher the potential rewards.
However, Mr. Money needs to keep in mind that not all risks are the same — some risks can be minimized, while others cannot be avoided.
Unique risks are risks that are directly related to the investment Mr. Money purchases. For example, an investment in a growth equity fund carries with it the risk that common stock prices will fall.
In contrast, a bond fund investment has the risk of a loss in value due to a change in interest rates. As interest rates rise, the price of bond funds decline, and vice versa.
These “unique” risks can be reduced by diversification or the mix of financial assets that ensures that not all of your financial eggs are in one basket.
In contrast, market risk, the risk that asset prices decline due to the general downward movement in the market, cannot be avoided. History’s second best example of market risk is the market meltdown in the fall of 2008.
From the beginning of October 2008 to April 1, 2009 the S&P/TSX Composite Index dropped 2,773 or 24 per cent. No matter what the mix of assets in an investment account during this time, investors saw their assets decline in value.
Mr. Money’s net worth would have been dramatically lower by the spring of 2009. This is good example of market risk in the extreme.
Like so many investors, Mr. Money believed that diversification eliminated market risk. This was to say at the very least an urban financial myth. Diversification will minimize risks that are unique to individual investments but having a good mix of stocks, bonds and cash in an investment portfolio will not help avoid the risk related to the types of precipitous declines in markets that we experienced in 2008/2009.
Indeed, if there is a true “cure” for the effects of market risk it is time in the market, patience, and the bold confidence that your investment objectives reflect your ability to psychologically withstand a prolonged market correction, such as 2008/2009.
Remember, you are always in control of your financial destiny and patience is the key to maintaining this control.
Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.