The Globe and Mail, Report on Business
Published February 20, 2010

Watching the Olympics, the notion of risk is very clear. Athletes need to push it to the limit in order to get to that top spot on the podium. But to obtain the advantage, they risk missing a gate, catching an edge or taking an untimely penalty. They may risk injury or even death, as we found out tragically on Feb. 12. And, when they are going all-out for gold, they may jeopardize a trip to the medal ceremonies for a chance to win.

Like elite athletes, investors need to take chances to succeed. Risk is the fuel that drives long-term returns. But as opposed to the clarity of sport, it's a more muddled concept when it comes to investing. Consider the following three examples where there is often confusion around the risks.

Gold. Appropriately, the first is gold. Is the shiny metal a high- or low-risk investment? Well, it depends.

As a stand-alone holding, gold is extremely risky. There is no income stream that flows from it, and no promise of one. The buyer is speculating that the price will go up over time.

Of course, gold bugs don't see it that way. In their view, it's ordained that gold will rise. But an analysis of its price history, supply-and-demand fundamentals, and role in government reserves would suggest that price appreciation is far from assured.

As a part of a diversified portfolio, however, gold can reduce risk. In the past, its returns have had a low correlation to other asset classes, so it has the potential to smooth out a portfolio's overall performance. And if it's bought at the right price, it can also enhance returns.

ETFs. Exchange-traded funds are often viewed as being lower-risk investments because of their broad array of holdings. But lower risk versus what? When compared with the indexes the funds are replicating, there is little chance that investors will be surprised. The return they see in the headlines is what they'll get in their portfolios (minus fees and commissions).

But in terms of absolute return — the kind that pays the bills — index-based ETFs are generally more volatile than actively managed funds. That's because a majority of ETFs are market-capitalization based, which means the largest stocks make up the biggest proportion of the fund. The higher a stock goes, the more money that's allocated to it. This “momentum” style of investing tends to ride higher in good times and fall further in tough times.

For investors with a long time horizon, there is nothing wrong with sharper zigs and zags, but they need to be prepared for them.

Asset Mix. The third instance where the notion of risk gets confusing is with regard to asset mix.

It is generally considered less risky to have money parked in a bank account, invested in guaranteed investment certificates (GICs) or stuffed in a mattress. Compared with the stock market roller coaster, it's much safer.

In the very short term, that is the case, but when the objective is to increase capital and protect against inflation over a number of years, the mattress strategy is as high risk as you can get. To help replace a paycheque after retirement, investors need their portfolios to generate a return well in excess of inflation. To do that, they have to commit to owning long-term assets because, over time, bonds will beat cash and stocks will beat bonds.

Investors who held bonds and stocks over the last 25 years have benefited from the decline in interest rates and have seen their capital grow. They are affected by low current yields, but not as much as long-term GIC investors, who didn't use the bull run in bonds and stocks to build up their capital.

Real Risk. What we need to remember is that any definition of risk depends on what the objectives and time frame are. When short-term security is important, stocks and real estate are inappropriate. But for long-term investors, owning secure savings vehicles is the risky strategy.

Before I go back to the unambiguously safe vocation of watching the Olympics and taking in the party, I should highlight a risk that applies across all situations. It is one that, if not heeded, will guarantee that investors fail to achieve their goals. It's the risk of paying too much. No matter what the goals and strategies, it's important to pay a fair (or preferably better-than-fair) price for growth, income or a good mattress.