There is more to risk than volatility...

Quantifying financial goals in terms of your desired (required) rate of return and risk tolerance can be a highly subjective task. Though the purpose of applying portfolio optimization techniques is to seek out the maximum potential return given the applied constraints, how you perceive and react to various risks will define how your investment portfolio should in reality be constructed.

Moreover, though in theory an efficient portfolio (PDF) exists for every risk tolerance, your financial plan may suggest that you have already amassed sufficient assets to achieve your life goals with a more moderate rate of return, or conversely that your financial goals cannot be achieved given your current savings and investment strategies – your desired (required) return on investment must always be reflective of your current circumstance and financial goals ahead.

Though as investors we tend to focus on market volatility (price variance,) various other risks as outlined below have the potential to impede long-term financial success. Finding solutions which may help manage and moderate portfolio risks is the desired outcome of optimization.

Longevity

The potential to outlive your capital may be the most profound risk that you will face. Just as investing too aggressively can result in losses, the consequence of investing too conservatively may result in not having enough capital to support your lifestyle goals...more

Inflation

To ensure your purchasing power remains intact over time, it is imperative that after-tax returns exceed the Consumer Price Index; which for Canada has historically exceeded 3% per annum...more

Credit Risk

Credit risk refers to a company's ability to make good on a promise to pay (interest and principal) in a timely manner. Though most often associated with debt instruments (bonds and debentures,) credit risk may also reflect upon equity securities – the risk of default would lead many investors to liquidate positions in haste, causing prices to decline.

Although the owner of a bond has legal rights to future income (and/or assets in the case of bankruptcy,) evaluating creditworthiness is key – various rating agencies including Dominion Bond Rating Service, Standard & Poors, and Moody’s perform ongoing credit analysis for corporate and government debt securities.

Interest Rates

Fluctuating interest rates can have a profound effect on the price of an investment. For fixed income securities, risks related to fluctuating interest rates may be moderated by diversifying maturities and duration. Often laddered-term portfolios are recommended when interest rates are rising while extending term to maturity (and focusing on quality) is generally recommended in anticipation of declining interest rates.

Equity investments and real estate too may be inversely affected by fluctuating interest rates – rising rates generally negatively impact equity prices as investors reposition into lower risk yield alternatives. By contrast, declining rates are often a boon for equity markets and real estate alike as investors and corporations can borrow more economically for investment purposes.

Market Risk

While security specific risks may be moderated by way of diversification, market risk is always prevalent in portfolios; simply as a result of merely choosing to be invested (or not...) Though asset allocation and other risk management measures may be taken to help control price variability, ultimately it is how you perceive and react to these variances in market price which influence your long-run investment outcomes...more

Currency Risk

With Canada representing less than 3% of the global economy and with resource companies and Canadian financial institutions together representing more than 75% of Canada's stock market capitalization, diversification beyond our borders is both appropriate and necessary from risk management and opportunities perspectives. Though international diversification may serve to moderate risks on the one hand, there is the potential for increased currency-related risks – a strong (rising) Canadian dollar may offset capital growth and income earned by investing in foreign markets.

Emotions

Much has been written on the topic of investor psychology – while positive returns are expected and taken in stride, the emotional experience relating to poor results is always amplified. Though we often communicate that money is a means to an end and not necessarily the end-game, the reality is that market volatility can on occasion, cause even the most disciplined investor to waiver. Investor psychology is very much like the cyclical nature of the market itself; the ebb and flow of investor emotions (PDF) causing us to stray from what might otherwise be a perfectly sound long-run investment thesis…