Does risk even matter when it comes to investing? Why do people talk about risk-adjusted returns? If I can get more return, I should just take on more risk, right?
Let’s take a step back and talk about what risk really means when investing?
When I think of risk, I usually imagine the volatility of the investment (how much it tends to move up or down in a day, a week, a month, or longer).
Let’s take a look at two different investments:
- 2-year GIC (Guaranteed Investment Certificate) paying 0.50% interest per year
- Royal Bank shares paying a dividend of 3.73% per year (as of March 10, 2021)
On the surface, the shares of Royal Bank seem like a much better investment choice. Who wouldn’t prefer 3.23% more per year?
Now let’s take a look at the risk aspect.
With a GIC, your capital is guaranteed by the institution it’s held with (usually a large financial institution). This means that your risk is almost zero.
When you own shares of any company, your capital is not guaranteed. Your investment value will fluctuate with the value of those shares. For example, since 2018 the value of Royal Bank shares has dropped more than 10% from their highs 3 times. This includes the Feb 21, 2020 - Mar 20, 2020 where they saw a 28% drop. Since then, the shares have recovered and then some.
The question now is: How will you react when you see that 28% drop in value? Will you panic and sell? Will you hold the line? It takes an iron stomach at times to weather the storms you will likely face and the urge to sell and cap your losses can be very strong.
In my opinion, that is the true risk. Panic selling when the investment drops in value suddenly. That is a sure-fire way to lose money. On the other hand, if you can close your eyes when the going gets tough, you’re very likely come out the other side ahead.