By Mike Fortunato, CIM®, FCSI®

 

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In the last two instalments in this article about risk we took a closer look at Volatility Risk & Shortfall Risk. Today I’m going to breakdown my thoughts on Absolute Risk.

Absolute Risk

When I refer to Absolute Risk I’m talking about the type of risk that is often associated with insurance. Absolute risk is any risk where there is no possibility of gain; there is only the risk of loss. Examples would include events like: health issues, losing a job, or any sudden, unplanned expense. Although Absolute Risk doesn’t affect an investor’s portfolio directly; it does damage an investor’s overall financial position, and usually impacts their investing behaviours.

I’ve witnessed many investors drastically alter their investment plan after experiencing an unexpected loss. For example, after losing a job, many investors frequently stop contributing to their retirement accounts, and some investors even go so far as to withdrawal from their RRSP triggering withholding taxes and other penalties. As we saw in the last instalment, one of the most important variables in reaching a financial goal is saving regularly; and this is where Absolute Risks can do the most damage. Your money can’t grow if it is not invested, so during an emergency, time spent on the sidelines that isn’t automatically contributing towards your goal will equate to more time needed to reach your goals. Also, withdrawing a sizeable portion of your goal to cover an emergency can be even more devastating because not only are you not contributing, but now there is less left in the pot to grow.

There is one more hidden risk that can result from an Absolute Risk materializing. An Absolute Risk can expose you to unplanned Volatility Risk. As I mentioned in the second instalment of this article: when properly managed, Volatility Risk is only a threat when investors are forced to sell their investments at an unplanned time. When such an emergency occurs, it might force a sale at a price lower than what they expected. This will exacerbate the negative effects towards their investment goal because they’re forced to sell more shares than expected, which adds more time to their recovery. Although this may seem like an unlikely doomsday scenario, it is actually a reality for many investors, as most employers are forced to lay off employees when the economy is doing poorly, which also tends to be when the investment markets are performing poorly.

Many investors have a poor plan, or worse, no plan to manage Absolute Risks. In fact, most of the investors I’ve encountered view their investment accounts as quasi-emergency funds: their only alternate source of savings in the event of an emergency. This is the reason why Absolute Risk can really wreak havoc to an investor’s investment goals. The best way to manage Absolute Risks is by having both an emergency fund and having adequate insurance. The only way to ensure that an emergency will have no impact on your investments is to completely insulate your investments from that risk. I always encourage investors to compartmentalize their investment accounts, and mentally forget about them as a potential source of emergency cash, but this is easier said than done when a real emergency strikes. That is why investors should have an emergency fund and proper insurance before they start investing. I could write a whole article about how much emergency cash and insurance someone should keep on the sidelines, but a good rule of thumb would be to make sure the amount saved will realistically cover the cost of an actual emergency.

Absolute Risk was the third and final risk I wanted to discuss in this series. Although they don’t directly impact your portfolio, they can hurt your financial goals indirectly. In the next, and final instalment of this article I will discuss how all three of these risks are interrelated, and a strategy that investors can use to manage all three.