The Financial Advisor Guide to Investment Risk and Return
Self Study Course # 16
INTRODUCTION
What is Risk?
According to Webster's Dictionary risk is defined as:
Possibility of suffering harm or loss; A factor, course, or element involving uncertain
danger; the danger or probability of loss to an insurer; The amount that an insurance
company stands to lose; One considered with respect to the possibility of loss to an
insurer.
We live with risk every day of our lives. If we drive a car, we run the risk of being injured
in a car accident. If we are involved in dangerous hobbies, such as car racing, we run
the risk of being killed. If we bet on a horse race, or invest in the stock market, we run
the risk of financial loss. If we fall in love, we run the risk of emotional loss. Virtually
everything we do in life involves risk to some degree.
Even Charlie Brown from the Peanuts comic strip experienced risk. When he got ready
to kick the football, he never knew if Lucy would pull the football away leaving him to fall
flat on his back. Those of us who read the comics knew that his risk was high (she
always pulled it away). Charlie Brown was a risk taker. He always thought the next
time would be a success.
When analyzing risk, there are many elements to consider. Past success or failure is
one element that needs to be factored in. We know that some types of investments,
such as annuities, carry guarantees of minimum return, and they have past performance
histories, which allow the investor to evaluate probable future performance. Other types
of investments, such as speculative stocks (or any stocks for that matter) have no
minimum guarantees. Past performance does give the investor some ability to
speculate on future performance, but it is only speculation. That is why they are called
speculative stocks. There are no guarantees!
Investment risk is related to the probability of earning a return. The greater the chance
of low or negative returns, the riskier the investment is. Certainly, no one invests with
the idea of low returns or perhaps even a loss of principle. Everyone invests with the
hope of high returns. When Bill Gates started Microsoft, those who invested in his
company certainly knew there were no guarantees.
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Those investors looked at Gates and what he hoped to achieve and took a "risk" with
their money. Their risk paid off. However, for every Bill Gates and Microsoft, many
more new start-up companies fail. With each failure, someone probably lost money.
Investment risk specifically refers to the probability of earning less than the expected
return on an investment. Probability distributions provide the foundation for risk
measurement.
PROBABILITY DISTRIBUTION
Probability distribution can be defined as a set of possible outcomes with a probability of
occurrence attached to each possibility. Some investments have specific outcomes,
such as the annuity with the guaranteed minimum interest rate. Even the annuity has
another possibility, however. The minimum earning rate does not mean that the
insurance company will not apply a higher rate. In fact, most annuities pay several
percentage points higher than the minimum rate.
It should be pointed out that no investment is risk free. The T-bill for example is often
said to be risk free because the rate of return is guaranteed. This is often referred to as
a "zero risk investment.” In fact, every investment carries risk because every investment
must contend with inflation. Only the nominal returns of the T-bill may be guaranteed.
The real return cannot be. The real return refers to the actual buying power that the
investment ends up with.
REINVESTMENT RATE RISK
There is another investment risk called reinvestment rate risk. There are several types
of investments that must contend with this type of risk. The T-bill has a maturity date.
When the T-bill reaches this maturity date, the money must be reinvested in either
another T-bill or some other financial vehicle. If the prevailing interest rate has dropped,
the money will begin to earn a lower rate than it previously was. It is this risk of a lower
interest rate that is called reinvestment rate risk.
RISK TOLERANCE
Charlie Brown obviously had a high-risk tolerance. Why else would he repeatedly allow
Lucy to hold the football? It means how readily a person can cope with volatility - the
ups and downs of an investment or other situation.
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If an investor cannot live with the investment because of its volatility or perceived risk,
then obviously they should not be in that type of investment.
Volumes have been written about risk and what to do about it. Every financial strategy
is based on a balance of risk and reward. Measuring risk is the most difficult part of
choosing a financial strategy. Some people view putting their money into the stock
market as too risky, so they opt for a more stable investment avenue, such as a banking
institution. However, that may be even more risky with regard to retirement planning. It
all depends on a person's time horizon. Time horizon is the amount of time available
before the person will need their invested money. A thirty year old worker has another
thirty years to invest whereas a fifty year old worker has only about ten or fifteen more
years to invest.
If a person's time horizon is very short, they have to make some serious decisions.
They may want to put their money in short-term fixed-income investments. Those who
waited too long to invest for retirement has to consider:

Do I now need to invest in riskier investments so that I get higher returns?

If I loose my money in a risky investment, am I able to replace the lost money
through other avenues, such as earned wages? The older investor has fewer
working years to replace lost investments.

If I invest in conservative, less risky investment vehicles, will it yield enough income
to live off of during retirement?
The average retiree must be able to live at least twenty years without a working income.
Many people must make their money last much longer, especially women who have
longer life spans. Over a longer time horizon, these "safe" investments may not be as
wise. As with everything, different people have different opinions as to what is a shortterm time horizon verses a long-term horizon. Some view five years short, others long
enough to take a risk.
For those that view the stock market as a risk, they should look at the stock market's
investment returns over a number of five-year blocks to see how the market has
performed. Stock market historians and analysts can show that there has been no 20year period in which a person would have lost money in the stock market (as defined by
the Standard & Poor's 500 Stock Index) going back to the 1920”s.
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Mutual funds, which are stock portfolios, have gained popularity because risk is spread
out among many stocks rather than one.
People are scared by risks in the investment world. Thus people, especially younger
people, make the mistake of choosing only the most conservative investments such as
fixed-rate guaranteed investment contracts (GIC’s or Term Deposits) when they are
planning their asset allocation models. Why is investing in these GIC’s a money
mistake? The answer is because it is investing too conservatively in investments without
growth potential.
A critical ingredient in risk is time.
Again, the critical ingredient in risk is time. Each person will define his or her time
horizon differently. Some people may not need the entire principal for quite a long time,
but they still want to keep of the principal in short-term investments. We see many
people who continually use Certificates of Deposit, or Term Deposits for example, even
though they are traditionally low yielding investments.
One of the most important things in overcoming risk is knowledge of the investment. It
is common for people to invest in something merely because George at work did so, or
Aunt Mary thought it sounded wonderful. No agent should ever recommend an
investment without understanding it completely. Not only is it possibly a money mistake
for the client, but it is also an errors and omissions mistake for the agent.
When investing, it is important that a person is educated and that it be a well thought out
financial decision. Ethical investing has become popular, but it has also become known
as one of the more successful investment strategies.
It has become successful not because it has to do with the ethics of a company
(although there is that, too), but because ethical investing requires investigation.
How can an investor know if the company is bad on the environment or uses animals in
testing unless they first investigate the company? Because of this investigation, the
investor is also likely to uncover bad management, faulty management thinking, or failing
company returns. Whether investing centers on particular ethical concerns or desired
returns, investigation can mean the difference between success and failure.
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The relationship between risk and return is simple: the greater the expected return, the
greater the investment risk. Any company who promises higher returns is also
undoubtedly promising higher risk of investment capital. Every investor needs to realize
that some types of investment are risking not only interest earnings, but also invested
capital.
Many professionals define seven types of investment risk.
1. Inflation Risk
2. Interest Rate Risk
3. Business Risk
4. Credit Risk
5. Market Risk
6. Liquidity Risk
7. Portfolio Risk
1. INFLATION
Inflation risk could also be called long-term risk. Inflation erodes the purchasing power
of the dollar and lowers the rate of return on investments. Inflation risk turns cash
equivalent and fixed-income investments into high risk and low reward investments.
Time usually favors an investor but it can also work against them. The more time an
investment has to grow, the more time inflation has to rise as well. Our investments
need to grow at a higher rate than inflation.
For example, a person's cash equivalent and fixed-income investments are earning four
percent, but they lose five percent of their value to inflation.
The outcome: that individual will have has less purchasing power at the end of a year
than they had when they started. The novice investor seldom recognizes this loss due
to inflation. Most investors probably look only at the interest earnings on their yearly
statements. Few also consider the rate of inflation.
A person faces inflation risk with any investment that pays back a fixed dollar amount in
the future with no change of growth of principal.
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These types of investments would include Certificates of Deposit (CDs), bonds, money
market account and fixed annuities that do not have a quarterly or yearly interest
adjustment, which has the potential of matching the changes in inflation. Some types of
investments in hard assets, such as real estate, art, or collectibles might rise with
inflation. Of course, there are no guarantees of this. It was once popular to invest in
precious metals because they were thought to keep pace our even outpace inflation. In
recent years, fewer professionals tend to believe this. The stock market has the
potential for growth, which can offset the loss in purchasing power of the dollar, but
stocks can go both up and down. The investor is always wise to check out the stocks
they are buying. In addition, most professionals recommend the positive investing
approach when dealing with stocks. The positive investment approach means investing
in products the investor knows and understands.
Protection against inflation
One can protect themselves against the risk of inflation by simply following three steps.
These steps would include understanding inflation, alternatives and a balanced portfolio
(proper asset allocation).
Understanding inflation is the first step. Most people have a rough understanding of the
workings of inflation (what causes it and how it affects various investments and areas of
the economy in different ways) so that educated decisions can be made.
Understanding inflation will help an investor distinguish between the investments that
can reduce financial uncertainty and those that will only make an investor's problems
worse.
Inflation does not shower its affection on any one particular investment field.
A key point to remember is that inflation does not shower its affection on any one type of
investment field. There is no simple inflation hedge that will show profit because of
inflation. One of the worst consequences of inflation is the chaos it creates in the
economy and in the investment world. Because of inflation, nearly all investments go
through extreme cycles of boom and bust. That is why so much investing must be done
for the long term to really show a substantial yield.
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This could be seen in October 1987. At the close of the market on Monday, October 19,
1987, stocks in Canada and most other countries were down about 40 percent from the
highs they had established a few weeks earlier. Some stocks fared worse than others,
of course. Some portfolio managers actually profited from the crash. Three years
later, the average stock had regained its 1987 losses. The crash of 1987 appeared to
have no lasting effects. However, if you asked the many people who lost their jobs, or
the hundreds of securities firms that were forced into bankruptcy or the countless
thousands that had planned on an early retirement, they may say that there were many
lasting effects of the October, 1987 stock market crash!
It has often been suggested that an investor should measure in an inflation hedge.
Doing so is not so much a science, however, as it is an art. At one time, gold was
considered a hedge against inflation, primarily because it was something the average
person could understand (or so they thought). Gold represented money to most people.
In recent years, we have seen all precious metals as volatile as any other investment.
There really is no inflation hedge that is foolproof. The stock market, which was the
supposed inflation hedge of the 1960’s, has seen downturns. The real estate market's
boom of the late 1970’s and early 1980’s which seemed to be providing an inflation
hedge for many people, suddenly turned sour in late 1979. Bottom line: No investment
will profit from every stage of an inflationary cycle. Over the long run, stocks do perform
reasonably well as does most real estate. In the short run, continuous performance is
difficult to sustain.
Investment alternatives and techniques
The second step is to become acquainted with the wide range of investment alternatives
and techniques available to the investor. Few investments continually do poor or
continually do well. Most have difficulties as they respond to market conditions. As a
result, investors need to realize that what did poorly last year may be doing well this
year. Of course, the opposite can also be true (doing well last year and poor this year).
Professional investors supposedly know how to read market trends allowing them to buy
and sell to take advantage of good returns while avoiding poor returns. Realistically,
reading market trends is similar to predicting the weather. It is more of an art than a
science. The key word is "predicting.” Just like the weatherman is not always right,
neither is the professional investor.
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The best advice when it comes to investing is to make use of all the available data. The
more we know about an investment, the more we are likely to profit. It is the old adage:
invest in stocks you know and understand.
Benefits of a well-balanced portfolio
The final step in avoiding the risk of inflation is to construct a well-balanced portfolio so
that an investor can forget (almost) about their investments. The idea is to be able to
enjoy our life and be confident that our investments are protected. Our investments
should profit no matter how inflation evolves and no matter how and when it ends. Of
course, no investor should absolutely forget about their investments, regardless of how
well they are doing. While most are designed for the long term, we still need to keep
track of our money. A key consideration for an investor is that there is proper balance
among several different investments. During a time of inflation and high interest rates,
tax deferral is more important for dollar investments than for any others, since high
interest rates mean that dollar investments will be producing more taxable income.
Thus, a device for deferring taxes will be especially valuable if it can be used to shelter
assets denominated in dollars.
Diversification
A well-diversified portfolio is probably one thing every expert can agree upon.
Diversification is a concept that is backed by a great deal of research and market
experience. Diversification is the process of reducing risk within a portfolio. As the
number of companies increase, the level of risk should decline.
In addition to the number of companies, a person also needs to diversify their assets, by
purchasing a variety of stocks, bonds and real estate, if they so desire. To diversify
correctly, a person would need to buy a variety of at least 20 different stocks of different
companies in different industries. From a common sense standpoint, 20 stocks in 20
different technical companies is not diversification. Even though some may do well
even if others are not, the general market risk is too similar to be considered
diversification.
Mutual funds are sold with the idea of diversification. As the types of mutual funds
become more specific, a person must keep aware of the diversification of their total
portfolio.
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Risk reduction
The benefit diversification provides is risk reduction. Risk to investors can be defined as
volatility of return or standard deviation. This refers to the possible variation of
investment return. Investors would prefer returns that are relatively predictable and thus
less volatile. Of course, investors also want returns that are high. Diversification
eliminates much of the risk without reducing long-term returns. Understanding inflation,
investment alternatives, and how to acquire a balanced and well-diversified portfolio may
be the most intimidating aspects for an investor to overcome. It can be time consuming
and difficult, but it is ultimately worth it.
MEASURING RISKS
Professional money managers seek the maximum return for a given level of risk, while
also seeking the lowest risk for a given level of return. A rational investment strategy
dictates that investment options be ranked according to risk. This means that risk
should be measured and quantified.
Measuring some risks comes intuitively. Investors understand that an aggressive
growth stock has more risk than that of a Treasury Bill or that the chances of being hit by
lightening are higher than winning a lottery. We could safely say that all investors
understand obvious risks and their counterbalance, the reward opportunity.
Unfortunately, the differences of investment risk are not so clearly stated or defined.
For instance, which is a better buy given their levels of risk and return: Aggressive
Growth or European equities?
An investor's decision is most often based on asset allocation models or mutual fund
and/or sub-account investing because of their choice of provisionally managed
investments.
ALPHA & BETA
The investment industry has devised measurements for each. They are known as:
1. Alpha (reward).
2. Beta (degree of risk).
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1. Alpha
Alpha is an investor's expected return for the level of risk assumed. Beta measures the
quantified risk over a given time period. In each case, there will be variance that is
measured by the standard deviation. This anticipates the upside and downside
potential at a given level of risk. By definition, standard deviation is the opportunity for
gain versus the possibility of a loss at a given level of risk.
Alpha is important when measuring and comparing sub-accounts and money manager
performance. The performance should be measured over a specified period and it
should be measured and compared to its peers and industry averages.
2. Beta
The beta coefficient is one method of measuring risk. It relates the volatility of an
investment to the market as a whole. The market, or measurement index, has a beta of
1.00.
Standard deviation is the opportunity for gain versus the possibility of a loss at a
given level of risk.
Beta risk is an important consideration for professional money managers and investors
alike because the effective use of diversification can reduce residual risk. Beta
derivation is a straightforward concept. Most sub-account betas are accessible to
investors through numerous industry research publications and ratings services.
Lifecycle Beta
Beta can also be a measure of risk for an investor's stage in the lifecycle and general
attitude toward risk. There is no quantifiable measurement for either because both are
subjective. It does not take a genius to figure out that preservation of capital is more
important to older investors, while growth is normally more important to younger
investors.
It is important for insurance agents and brokers, financial planners or whoever is
discussing an investment portfolio with a client that they give them a realistic evaluation
of the worst-case scenario.
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Part of risk management is risk measurement. Several aspects of risk measurement
have been discussed. Degree of risk was shown to be measured by variation between
expected return and actual losses.
Probability of loss can be measured in three basic ways:
1. Frequency
2. Severity
3. Variation
1. Loss Frequency
It is important for risk managers, based on the past loss experience (frequency) of their
firms or that of similar classes of risk exposures, to predict variation risk in future losses.
The primary purpose is to help them decide what to do about various loss exposures.
Some losses may be found to be so infrequent that it would be uneconomical to try to
deal with them. Some losses may be so frequent as to be regularly anticipated.
2. Severity
If properly carried out a risk manager can properly measure the risk to aid in suggesting
the best way to treat the most important risks and possible losses.
3. Variation
With additional information about losses over a period of years, the trends and variations
in losses and gains over a period of years can be estimated with more of an educated
guess.
Measuring Risk Further
A probability distribution has been defined as a set of possible outcomes with a
probability of occurrence attached to each outcome. If an investor is considering five
different investments, there is five probability distributions; one for each of the five
investment alternatives. For instance, if an investor was interested in T-bills, the rate of
return is known for a certainty, no matter what the economy does to the interest rates.
Thus, you could say that the T-bill has zero interest rate risk (it does have inflation risk).
No investment is risk free. Although, the T-bill may have zero interest rate risk, it still
carries another kind of risk. When the T-bills mature and reinvestment is required, the
current interest rates may have declined. At this point, the portfolio's income will drop.
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This risk is called reinvestment rate risk. As the name implies, the risk is connected to
declining interest rates. A lower earning interest rate means lower returns for the
investor.
If the investor were considering corporate bonds, stocks, annuities, mutual funds or
whatever, the return on the investment would not be known until the end of the holding
period. Since their outcomes are not known with certainty, the investments can be
defined as risky.
Probability distributions may be either:

Discrete

Continuous.
A discrete probability distribution has a limited number of outcomes. There is only one
possible value, or outcome, for the T-bills' rate of return, although for other investments
there are alternative outcomes. Each outcome has a corresponding probability of
occurrence.
If an investor can multiply each possible outcome by its probability of occurrence and
then sum these products, they will have a weighted average of outcomes. The weights
are the probabilities, and the weighted average is defined as the expected value. Since
the outcomes are rates of return, the expected values are expected rates of return.
Expected Rate of Return
The expected rate of return on an investment or portfolio is simply the weighted average
of the expected returns of the individual securities in the portfolio. Normally,
investments with higher expected returns have larger standard deviations (more risk
involved) than investments with smaller expected returns. To better explain what
standard deviation is, let's look at an example: let's say Investment A has a 30 percent
expected rate of return and a standard deviation of 10 percent, while Investment M has
an expected rate of return of 10 percent and a standard deviation of 5 percent. Which
looks better? Which would you recommend?
If the returns of Investment A and Investment B are approximately normal, then
Investment A would have a very small probability of a negative return in spite of its high
standard of deviation.
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While Investment B, with its lower standard deviation figure, would have a much higher
probability of a loss. Therefore, to properly understand the implications of standard
deviation as measures of the relative risks of investments whose returns are different,
we need to standardize the standard deviation and calculate the risk per unit of return.
This can be accomplished by using the coefficient of variation (CV), which is defined as
the standard deviation divided by the expected value.
The bottom line
Investment B actually had more total risk per unit of expected return than Investment A.
This means that one could debate that Investment B was riskier than Investment A, in
spite of the fact the Investment A's standard of deviation was higher (10 percent verses
5 percent).
Maximum Possible & Probable Loss
Risk managers can divide potential losses into various categories of importance to their
firm. Classifications may be established, such as those losses, which are high,
moderate, or of slight importance. Estimates of maximum possible loss, the worst that
can happen, and the maximum probable loss, the worst that is likely to happen are
valuable measures.
Probably the most useful to risk managers is the concept of maximum probable loss
because by using some actual or even hypothetical data, the probability that severe
losses might occur can be observed and measured. Some extreme possibilities that
are possible, but not likely, are disregarded in the estimate of maximum probable loss.
Living With Risk and Return
The concepts of risk and return have been analyzed as separate entities. I hope that
most investors, as well as the agents selling to them, understand the positive correlation
between risk and return. Increased risk should offer increased return. Decreased risks
also mean decreased returns.
Rising interest rates cause falling bond prices.
An investor may expect a safe return of five percent by purchasing risk-free investments
such as short-term certificates of deposit. Increasing our expected return above five
percent involves also increasing the investor's assumption of risk.
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The relationship between risk and reward differs between investors and with the everchanging business environment.
2. INTEREST RATE RISK
Interest rate risk applies to fixed-income investments such as bonds or CDs (Certificates
of Deposit). Generally, the bonds of any organization have more interest rate risk the
longer the maturity of the bond. This means a maturity risk premium, which is higher
the longer the years to maturity, must be included in the required interest rate. The
effect of maturity risk premiums is to raise interest rates on long-term bonds relative to
those on short-term bonds.
Interest rate risk can be divided into two categories:
1. Value Risk
2. Reinvestment Rate Risk.
1. Value Risk
Interest rate fluctuations can severely affect bond values and certificate of deposit (CD)
rates. Rising interest rates cause falling bond prices. Fixed-income investment unit
values decrease periods of sharply rising interest rates. If an investor owns a bond and
their market price goes down, it does not mean that they need to sell. If the investor
bought the bond for fixed income and they still expect to receive the full face value at
maturity, no money will be lost by holding them. The risk lies in the possibility of
needing to sell before maturity. In such an event, a lower price than paid would be
received. Therefore, a loss would occur.
Bond funds are especially vulnerable to value interest rate risk, because they have no
maturity date. An ordinary bond, which has lost value due to rising interest rates, can
be held until maturity, and the investor will receive the full face value - no money is lost.
However, because bond funds do not have a maturity date, there is no promise of
receiving the full value at maturity. Mutual funds are priced at current market value of
the securities held in the fund, which may or may not reveal or identify the depressed
market price of certain or specific individual bonds held within the portfolio of the fund
which may subject the investor to an uncontrolled depreciation in the value of his or her
investment or an unrealized loss depending, of course, on whether or not the manager
chooses to crystallize these losses by actually selling the affected security.
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2. Reinvestment rate risk
If interest rates fall after an investor invests, they will be reinvesting the interest
payments that they receive at a lower rate. Short-term bonds are highly exposed to
reinvestment risk. This means that when the investment matures, or if it is "called"
before maturity, the investor's choices of reinvesting the principal could result in their
earning a lower rate of interest. Therefore, while investing in short-term investments
preserves a person's principal, the interest income provided by short-term investments
varies from year to year, depending on reinvestment rates.
Call Risk
When an investment is "called" before maturity, it is termed Call Risk. Call risk is the
risk that a bond (investment) will be called or bought back before maturity by the issuer
on demand. Not all tax-free bonds are callable, but those that are may be called after
interest rates have declined. Calling a bond allows the issuer to reissue the bonds at a
lower interest rate. Normally the bonds are only called after the interest rates have
declined. The investors then have to reinvest their money at lower interest rates. This
is very similar to what homeowners do when interest rates fall - they refinance their
homes to take advantage of the lower interest rate.
Call Protection
Some bonds have call protection. This is a guarantee that a security cannot be bought
back by the issuer until a specific amount of time has gone by. Treasury securities are
usually noncallable.
3. BUSINESS RISK
Investors face business risk when they invest in such things as common stocks and
corporate bonds. If an investor has common stock or corporate bonds in a certain
corporation, this is the risk which faces an individual corporation from such diverse
sources as management error, faulty products, poor financial planning, market mistakes
and so on. If the individual corporation starts to experience income statements in the
"red", the investor's common stocks or corporate bonds may be in trouble. The most
severe trouble may be when this individual corporation files bankruptcy. Why?
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If an investor holds common stock, they are at the bottom of the list when it comes to
repayment. The investor is behind Canada Customs and Revenue Agency, lawyers,
banks, bondholders and preferred stockholders when it comes to getting any money
back.
How can an investor avoid business risk? The best way is simply diversification. If
stocks of individual companies are held, it is recommended that no less than 15 different
stocks be purchased individually or through mutual funds. When an investor has a
"cushion" of 14 other companies, experts say that the business risk of any one company
is effectively diversified.
An investor's income can decline due to a number of reasons occurring naturally in the
business environment. This is important to money managers when making individual
securities investments. It is less important to investors who have hired money
managers to analyze the risk of individual securities. It is important, however, for
investors purchasing individual securities.
Business risk, also called diversifiable risk or unsystematic risk, can also be caused by
such company-specific events as lawsuits, strikes, successful and unsuccessful
marketing campaigns, and winning and losing major contracts. Again, since these
occurrences are unique to a particular industry or firm, they are essentially random and
can be compensated for through diversification. It cannot be overstated that an investor
can diminish their business risk (diversifiable risk) by sending their investments to a
variety of industries or firms - thus diversifying.
4. CREDIT RISK
Credit risk, also termed Default Risk, is the risk that the borrower cannot pay back the
interest or principal they owe the investor. This is why corporate and municipal bonds
are risk-rated by rating agencies. Investments with a lower credit rating pay a higher
rate of interest because investors generally demand more interest to compensate for the
possibility (risk) that the issuer may default. We see this higher rate usage in just about
any type of loan where default of repayment is a possibility. Even mortgage loans and
car loans impose higher rates for those with a higher risk of nonpayment.
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Canadian Treasury securities or Canada Savings Bonds have no credit risk, thus they
have some of the lowest interest rates on taxable securities in Canada. Treasury
securities are free of credit risk because a person can be virtually certain that the federal
government will pay interest on its bonds and will pay them off when they mature. For
corporate bonds, the higher the bond is rated, and the lower its credit risk, the lower the
interest rate charged.
The greater the credit risk, the higher the interest rate issuers charge. No one would
invest in something that offered a high amount of risk and low returns.
5. MARKET RISK
Non-diversifiable Risk or Systematic Risk
Market risk is a type of risk that remains even in a diversified portfolio. Market risk
pertains to the factors that affect the economy as a whole. Since economy factors can
be good or bad, it can effect investments negatively or positively. This, in effect, causes
investments to change in value regardless of the fundamentals of individual investments.
The market value of an investment can vary substantially over short periods. Market
risk lessens over time.
Market risk, or non-diversifiable risk, comes from external events such as war, inflation,
recession and high interest rates, which have an impact on all of the economy. Since it
is "all" affected at once by these factors, market risk cannot be eliminated by
diversification. It can be reduced, but not eliminated.
Market risk can also be called systematic risk because it shows the degree to which a
stock moves systematically with other stocks.
An investor cannot control market risk. An investor could not have stopped the stock
market crash of 1987, which is an example of stock market risk. An investor could not
have stopped the economic downturn of the early 1990s, which is an example of market
or economic risk for real estate investments.
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What is Total Risk?
Total risk refers to how risky an asset is, that is held in isolation. This would apply if an
investor held only stocks from Air Canada or Nortel. The stock's risk is measured by the
dispersion of returns on its expected returns. The greater the dispersion, the higher the
chances that the return will be below the expected return, which in turn means the
individual stock holds a greater risk.
However, when an investor practices asset allocation diversification total risk can be
reduced. When an investor holds a large number of different types of stocks in their
portfolio, then the importance of an individual stock becomes less risky. A stock or
asset that would be considered risky by itself (held in isolation) may not be risky at all, if
it is in a diversified portfolio. In other words, the risk of one of the stocks is offset by the
gains of another. In this case, the relevant risk of each stock is its market risk, which
measures the stock's contribution to the overall volatility of the portfolio.
With this in mind, we can see a clear picture of how the greater the impact of a stock on
the overall riskiness of a portfolio, the higher the market risk of the stock. A stock's risk
is affected by its total risk, but it is also affected by the connection of its returns with the
returns on a portfolio of stocks.
Total and market risk affect all types of investments such as securities, stocks and
bonds, real estate, precious metals, corporate capital investments and so on.
6. LIQUIDITY RISK
Liquidity risk refers to the ability to "cash out" an investment. The risk of cashing out
refers to the ability to sell the investment quickly without losing principal. An investor
may have an appraised value of their home or stamp collection, but that won't put cash
in their pocket if they cannot find a buyer who is willing to pay the appraised price.
Liquidity risk affects investments that do not have active secondary markets and
investments that are in very volatile or cyclical market, such as real estate.
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7. PORTFOLIO RISK
Market risk refers to the market as a whole. An investor cannot control market risk.
Market and total risk could be reduced by diversification. Then there is portfolio risk.
Portfolio risk is the expected return on a portfolio as a whole. This type of risk can be
measured.
The expected return on a portfolio is the weighted average of the expected return of the
individual investments in the portfolio. The realized rate of return on the investment
may be seen a year or so later. What an investor expects and what they actually
receive (realize) are two different things.
Where the return portion of the investment can be measured, the standard deviation of a
portfolio is normally not a weighted average of the standard deviations of the individual
investments in the portfolio. Each stock's contributions to the portfolio's standard
deviation are not either.
Theoretically, then, it is possible to combine two stocks that are individually risky, as
measured by the standard deviations, and to form from these risky investments a
portfolio that is completely free of risk.
Covariance & Correlation Coefficient
The riskiness of a portfolio is measured by the standard deviation of its return
distribution.
Two keys concepts in portfolio analysis are:
1. Covariance
2. Correlation coefficient.
Covariance is a measure that reflects both the variance (or volatility) of a stock's returns
and the tendency of those returns to move up or down at the same time other stocks
move up or down.
For example, the covariance between Stocks A and B tells us whether the returns of the
two stocks tend to rise and fall together and how large those movements tend to be. If
the covariance turns out to be zero, this indicates that there is no relationship between
the variables. The variables are independent.
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Since it is difficult to interpret the magnitude of the covariance term, the correlation
coefficient is often used to measures the degree of covariance movement between two
variables. The correlation coefficient standardizes the covariance by dividing using a
product term. This facilitates comparisons by putting things on a similar scale.
Efficient Portfolios
Of course, a person would want to select a portfolio design that is efficient. This would
be defined as a portfolio, which provides the highest expected return for any degree of
risk or the lowest degree of risk for any expected return.
For example, let us assume that we have Security A and Security B and we have a
specific amount of money to invest. We can allocate our funds between the securities
in any portion.
Security A has an expected rate of return of 5% and a standard deviation of return of
4%. Security B has an expected rate of return of 8% and a standard deviation of return
of 10%. This means that Security A has an expected rate of return of 5% but could
deviate (swerve) 4% up or down. The investor could end up with a rate of return at 9%
or as low as 1%. Security B has an expected rate of return of 8% but could deviate
(swerve) 10% up or down. The investor could end up with a rate of return as high as
18% or as low as -2%.
How would we set up our asset allocation or our portfolio for the most efficient use? This
would depend upon what age the investor is and what they expect from their portfolio.
ASSET ALLOCATION
Asset allocation is the process of deciding where to invest. Most people do understand
diversification, so asset allocation entails deciding which portion of the available
investment funds go to which investment. This might include such things as annuities,
stocks, mutual funds or real estate, to name a few. Each category of investment may
be further divided. For example, the portion that a person may want to invest in stocks
would normally be divided between directly owned stocks and stock mutual funds.
Within the stock mutual fund, a person must decide if they want to invest in higher risk
funds or conservative funds, thus another layer with each investment made.
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A person can make the job of asset allocation very hard if they chose to. A person can
consider many different and potentially volatile factors in deciding how to invest their
money, including stock market conditions, interest rates, economic prospects, tax
regulations, and the person's own personal finances. This is one big reason why people
do not pay attention to asset allocation. They do not want to take the time to look at the
big picture. Normally, people tend to focus on one investment such as stock mutual
funds, a municipal fund or some other investment of interest to them. There is a risk
involved with not paying enough attention to asset allocation: there may be no long-term
investment plan. A person's investment plan could be inappropriately allocated. In
these instances, a person may not find out until it is too late. The other extreme is the
person who is so obsessed with all the expert opinions that they move their investments
all over the place and too often. This has been shown to also be an inappropriate
allocation.
Permanent Portfolio Structure
A permanent portfolio structure is maintained over a long period with only minor
changes; sometimes no change at all is made. A person should decide if they are a
conservative, moderate or aggressive investor before establishing a permanent or nearly
permanent investment strategy. Once a person has decided, there really is no reason
to vary the investments. It has been shown that people who keep their investments
relatively stable in a mixture of investment vehicles do very well over a long period.
This does not mean that a person should never make any changes. It only means that
a person should not make rapid or frequent changes to their portfolio.
Guidelines for Asset Allocation
Investors who like to invest in extremes may think they are well diversified. Even so,
they may be overlooking some kinds of investments that may help them achieve
investment success. An investor should decide how much their total investments they
wish to invest in each of the three primary categories (stocks, interest earning
investments and real estate). Not everyone will want to invest in all three categories,
but for the broadest diversification, it would be advised to do so.
For younger and/or middle age people, they should weigh their investments in favor of
stocks and real estate if they so wish.
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This is because these investments have the best chance of beating inflation risk and
producing long-term returns. A portion of the portfolio should be allocated so some of
the portfolio remains conservatively invested.
People who are within about ten years of retirement should begin gradual shifts to more
conservative investments. This decreases their market risk since they will need their
money sooner than a younger investor and would be subject to market losses. Shifting
a pre-retiree's investments to more conservative "safe" investments lessens the risk of
being caught in a stock market downturn or a real estate slump.
For people who are already retired, the amount that is in riskier investments depends on
how much they rely on their money to live on. If retirees need this money to live on,
they may require investments that yield current income either with interest earning
securities or dividend paying stocks. It may be wise for a person not to neglect stocks
because they may need capital appreciation to fund a long retirement. Many retirees
find that they have time to devote to the stock market and do quite well.
EXPECTED RETURN
The expected rate of return on a portfolio or combination of assets is simply the
weighted average of the expected returns of the individual securities in the portfolio.
Generally, an asset held as part of a portfolio is less risky than the same asset held in
isolation. This is not so hard to understand. An asset that would be considered
relatively risky if held in isolation may not be risky at all, if it is held in a well diversified
portfolio. In this instance, considering risk in a portfolio could completely change a
decision based on an analysis of total risk.
How Much Return is Required to Compensate for a Given Amount of Risk?
As we have determined, the riskiness of a portfolio is measured by its standard deviation
of returns. This is generally less than the average risk of the individual assets within the
portfolio. Since investors should and normally do hold portfolios of securities, it is
reasonable to consider the riskiness of any security in terms of its contribution to the
riskiness of a portfolio rather than in terms of the risk for a singular security held in
isolation. Capital Asset Pricing Model (CAPM) specifies the relationship between risk
and required rates of return on assets when they are held in well-diversified portfolios.
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TREATING RISK
We have discussed the identification of risk and how to measure risk. We now need to
discuss the treatment of risk and/or the administration of risk. A pitfall that some people
fall into is assuming that there is a single method of treatment in the solution of risk. In
reality, it is much more common to find all or at least several techniques used together to
provide the best solutions for meeting the financial problems of risk.
Two Basic Methods
There are two basic methods of treating risk:
1. Risk control in order to minimize losses.
2. Risk financing in order to reduce the costs of those losses that do occur.
In just about every case, it is not merely which to choose from (risk control or risk
financing). Good risk management requires that both be used in methods of treating
risk.
1. Risk Control
Risk control involves a number of alternatives. These alternatives are not limited to
using just one. The goal is the proper choices, using all methods, which results in
benefits that exceed the costs. Many associations use all or most of the techniques in
order to best handle the diverse types of risk.
The alternatives include:
A. Risk avoidance.
B. Separation, diversification, or combination of loss exposures.
C. Loss prevention and reduction.
D. Some non-insurance transfer loss.
2. Risk Financing
Risk financing also includes many alternatives that can be used separately or in
combination with one another and with the previously identified risk control measures.
Financing methods are subdivided into two different categories:
1. Risk retention.
2. Risk transfer.
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Risk retention helps provide different types of funding when paying for losses, absorption
in expenses, special reserves, funds, deductibles, self-insurance and captive insurers.
Insurance is the most common type of risk transfer, but some non-insurance transfers of
risk and credit mechanisms are also useful.
RISK CONTROL ALTERNATIVES
In each of the alternatives, the primary goal is to achieve the purpose of minimizing
losses that might occur to asset and income.
A. Risk Avoidance
This is probably the most obvious choice - avoid risks entirely, at least to the extent
possible. Some types of risk are either not assumed or are abandoned altogether. For
instance, a person could choose not to buy a home in order to avoid the risk of losing the
home value through the peril of fire or real estate declines. Some risk must be assumed
simply because we are alive. It would be impossible to avoid all risks entirely.
Financial risks can be avoided to some extent. What usually happens, however, is that
one risk is simply traded for another. For example, the person who is afraid of stock
market risks may never invest anywhere at all. Therefore, they have traded the risk of a
market downturn for the risk of poverty in their retirement years. That same person
could have saved through another vehicle and avoided stock market risk while still
saving for their retirement years. Risk avoidance is a common factor for most people
when they invest. They avoid certain stocks, but purchase others. They avoid certain
life activities, such as skydiving, but participate in others, such as water sports. Even
deciding where to live can involve risk avoidance.
Most people buy homes in areas they consider safe. Total avoidance of risk is no
practical solution to the many risks that are involved in normal day-to-day life. Some
unusual risks with a high chance of loss can be avoided, but realistically the avoidance
of risk is only an alternative about a restricted number of economic risks. Some risks
may be impossible to avoid. Others may not be economically desirable, either because
the benefits outweigh the costs or because avoiding one risk may create another. For
all avoidable risks, other solutions must be considered.
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B. Combination, Segregation & Diversification
The combining of exposures to loss is a common method of risk control. This method
broadens the units of exposure and may aid in predicting future losses. Combining
risks may spread the risk and create more stability in loss experience. This can be seen
when combining singular investments that may be rated very aggressive or "risky" into a
portfolio that equalizes them out, thus their risk rating may go down. Combination is a
basic principle of insurance and self-insurance and it may be used in many other
business situations.
Generally, the combination risk reducer process has to be in combination or conjunction
with other methods. For instance, for the combination method to be most effective, it
should be used in conjunction with segregation and diversification or with other methods
of risk financing. Just combining exposures is not the most effective way to reduce risk.
In some cases, it may increase risk more than decrease it if the added exposures are
more concentrated or variable than the previous exposures.
Segregation is the separation or dispersion of loss exposures. It is often an effective
way of limiting the severity of loss by reducing the concentration of exposures.
Diversification uses different types of loss exposures as opposed to having only one type
in order to improve one predictability. When assets are duplicated at different locations,
the diversification technique is being used. Investing money into different types of
investments is a way diversifying.
C. Loss Prevention & Reduction
Loss Prevention and Loss reduction could be considered separately, but because they
are so closely related, we will discuss them as one.
Loss prevention may involve the elimination of the chance of loss and thus risk. More
often, a reduction in the probability of loss is accomplished. Loss reduction has the goal
of reducing the severity of loss, which includes the steps taken to accomplish this either
before or after a loss.
The techniques used to help prevent or reduce loss are often logical. This is important
since losses are rarely completely taken care of by just one method.
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Preventing or reducing risk makes sense if it can be done for a reasonable cost in
relation to its potential benefits. If human life were at stake, cost may become
secondary.
Loss prevention and loss reduction is not the same thing as risk reduction. The risk or
uncertainty of variable losses may still be the same, while the chance of decreasing loss
or value is reduced. There may be a reduction of the conditions increasing the ratio of
the likelihood of hazards to the cause of loss.
Much more could be said about loss prevention and loss reduction because this applies
to so many fields including insurance agents, financial planners, brokers, consultants,
insurers and insured’s.
D. Non-insurance Transfers
Non-insurance transfers are affected by means of a contract, other than insurance, in
which one party transfers to another the legal responsibility for property or employee
losses. A method of risk financing transfers the financial burden of the transferor.
Subcontracting is one example of non-insurance transfer. When a company wants to
build a building, they subcontract the electrical, plumbing, drywall and framing to outside
companies. Those companies are financially responsible for the injuries those
employees may face on that job, thus the financial burden or risk of loss is transferred or
subcontracted out to another company.
Licensing is another example of non-insurance transfer. Under licensing contracts, a
manufacturer that does not want to produce or sell certain goods can transfer some of
the responsibilities. The manufacturer would receive only a royalty or fee for licensing
others to do the work. The licensees would have the responsibility for injuries to their
own employees.
RISK FINANCING ALTERNATIVES
Using methods of risk control in most cases only lessens the loss. One exception to
that is risk avoidance in which the probability of loss or risk is eliminated. All the other
methods of risk control still incur losses. Because of this, some additional choices are
necessary in deciding how to pay for them. The two major types of risk financing will
explain these choices in methods of risk financing: risk retention and risk transfer.
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Risk Retention
If a certain risk has not been avoided, a person may decide to keep it. This is called risk
retention or risk assumption. The residual risk must in some way be paid for.
There are five basic methods for paying for the residual risk:
1. Absorption in operating expenses,
2. Funding and reserves,
3. Deductibles and excess plans,
4. Self insurance, and
5. Captive insurance.
Lack of planning is probably the way most pure risks are retained. Some risks are
retained because the existence or importance of the risks are not known. Lack of
knowledge or the inability to reach the right decision even with accurate knowledge may
result in assumption or retention of risks. The information a person may require may
not be available or the information may be available but not used. We often see others
take risks that we ourselves would not be willing to take. Perhaps our neighbors are
willing to own a home, but not willing to purchase fire insurance. Perhaps someone we
know is willing to build his or her home on a site with poor drainage.
Whatever the peril, some will be willing to accept risk while others will not. Unplanned
retention of risk may also result from unintentional, irrational action or from passive
behavior due to a lack of thought, laziness or lack of interest in discovering the possibility
of loss.
The important risks that people face day to day that could cause a financial hardship are
the risks that must be paid for in some way. This is planned risk retention and is one
method for risk retention. Planned risk retention happens when it is the result of
purposeful, conscious, intentional and active behavior.
We could ask ourselves what reasons are there for using risk retention? The reasons
are simple:

The necessity.

Control or convenience.

Cost.
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Some pure risks can only be financed by retention. The risks are knowingly retained by
necessity and are impossible to transfer. A certain market for insurance may
temporarily be unavailable because there is a high probability for loss or a bad
experience of loss. If this is the case, retention is necessary until the competitive world
markets make adjustments permitting risk transfer.
Retention of risks may be used because individuals or businesses want the control
and/or convenience of paying for losses themselves. Regardless of cost comparisons,
some may want to have the benefits of direct and complete control.
A major consideration of risk retention is the cost. A comparison of the cost involved in
each alternative method of financing losses is necessary. For instance, how much
would it cost to insure a building for earthquakes verses building the building to
withstand an earthquake? Another consideration is loss frequency and severity. All
costs of the various alternatives, including indirect and direct costs are needed for fair
comparisons.
Risk Transfer
Risks and losses that cannot be retained by individuals and businesses may be some of
the most important to insure against. The primary method for consideration is the
transfer of as much as possible of the unpredictability (the loss) to someone else.
Three ways or methods are possible:
1. Credit arrangements
2. Some non-insurance transfers
3. Insurance
Credit Arrangements
The use of credit arrangements or contracts to pay for losses may be considered as one
way to transfer risk. However, borrowing money usually has another purpose, such as
financing homes or business expansions. Since credit is always limited, it seems
generally unwise to use credit for relatively unpredictable needs. Pure risks, especially
for larger and infrequent loss are difficult to handle by borrowing after the need arises.
In fact, a person may be adding the additional risk of not being able to obtain credit. It
would generally be wiser to transfer these risks to others.
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Non-insurance Transfers
Several other types of non-insurance transfers may transfer risks to others. A hedging
contract is one method of transferring some speculative (loss or gain) risks. Sometimes
this balancing of possible profit and loss through two offsetting contracts is called
neutralization. This method cannot be used for pure risk, which involves no possibility
of gain. Under neutralization or a hedging contract, there must be two possibilities: loss
or gain.
Another method is the hold-harmless agreement. Most non-insurance transfers for risk
financing deal with liability risks and the hold-harmless agreement is the best example of
this. In this contract clause, the transferee agrees to hold the transferor harmless in the
case of legal liability to others. The transferee agrees to pay claimants or to repay such
losses if they fall on the transferor. If the transferee is unable to pay the losses, the
ultimate responsibility remains with the transferor.
There are several types of legal contracts that commonly use the hold-harmless
agreements. In lease contracts, for example, a wide variety of legal responsibilities are
transferred from one party to another through hold-harmless agreements.
Insurance
Insurance is the most common type of risk transfer method used. A definition of
insurance may be developed from several viewpoints:

Economic

Legal

Business

Social

Mathematical
No matter which viewpoint is used, a full interpretation should include both a statement
of its objective as well as the technique by which its purpose is achieved.
When we enter the field of insurance as a means of transferring risk, multiple types of
risk transfer must be considered. We have primarily considered investment risk so far,
but insurance transfer deals with virtually every type of common-day activities and the
risks associated with them. Insurance covers our health, our homes, our motor
vehicles, our liability to others, and virtually anything else one can dream up.
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In fact, some very unusual policies have been written for people who are willing to pay
the premiums.
Insurance companies, who assume our every day risks, employ actuaries. These men
and women determine whether or not an insurance company is willing (from an
economical standpoint) to assume the risks of another person or entity. It is their job to
predict what the possible losses and gains are for the insurance company based on the
facts. Sometimes there are few facts from which to make these predictions, especially if
the field of insurance is new.
In simple terms, insurance is merely the transfer of risk from an individual or a business
to the insurance company. With that transfer of risk, transfer of a possible loss also
happens. If enough people or businesses are interested in transferring a particular risk,
the cost of doing so becomes relatively inexpensive. That is why we see life insurance
policies (which insure against premature death) so affordable.
Lots of people buy the policies, so the insurance company can offer affordable rates. Of
course, competition also has some bearing on cost. When lots of people want
something, the field becomes competitive.
When lots of people or businesses wish to insure the same risk, the role of the insurance
company actually changes. While they do assume the individual risk, as a group risk,
the danger is not longer as great. This group risk causes the science of probability to
change. The probability laws of large numbers now apply. It is much easier to predict
losses for a large group, but much harder to do so for an individual. Since the
insurance company does not need to know precisely who will suffer the loss, they can
predict their personal losses (as the insurer) for the group as a whole. Actuaries are
surprisingly accurate at determining how many out of the group of insured will
experience losses. From these figures, the insurance companies can set their premium
rates that will provide the funds necessary to meet expected losses, plus the expenses
incident to the conduct of business.
Everyone wins. The individuals might be able to completely shift the risk, and the
insurance company, while assuming that risk, makes a profit.
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Even though premium rates can be developed that are very accurate, it would be
unusual for them to be "on the mark.” Inevitably, the number of losses that actually do
happen will be slightly above or below the predictions. Insurance companies know this
and hedge for the possible higher losses. The same is true for investments. The
earnings may be higher or lower than expected. While this affects individuals who
invest, it also affects the insurance companies. They, too, invest. They invest the
premium dollars as part of their hedge against higher than anticipated losses. We have
sometimes seen insurance companies who were not as competent as they needed to
be.
Law of Large Numbers
Insurance companies use the "law of large numbers" to predict their losses. It is true
that the use of insurance reduces the risk. It may be difficult to understand why a
pooling of the risks would actually reduce them, but this is the case. The law of large
numbers is often referred to as the law of averages. Although it is called a "law", it is
actually an entire branch of mathematics.
In the 17th century, European mathematicians were constructing crude mortality tables.
From these, it was discovered that the percentage of male and female deaths among
each year's births tended to be constant if sufficient numbers of births and deaths were
tabulated. It was Denis Poisson, in the 19th century that named these tabulations the
law of large numbers.
Why would individual risk be higher than group risk? The answer lies in the quantity of
participants. The law of large numbers, or the law of averages, is based on the
regularity of events. What seems random when it happens to an individual could be
predicted when put in the context of a group. While group predictions cannot say who
will experience the loss, they can say that it will happen to someone within the group.
So, the only reason an individual cannot say what will happen to them personally is
because they do not have sufficient mathematical information. To gain this information,
they must become part of the group. Again, this will not tell the individual whether they
personally will be affected, only that someone within the group will be.
What appears to be chance, results with surprising regularity as the number of
observations increase.
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We see this every day on the nightly news. We just do not recognize it as the law of
large numbers, sometimes called the laws of probability. Not only insurance companies
use these mathematical statistics. Gambling establishments know these laws well.
They know with surprising accuracy how many people will win and how many will loose.
They just do not know who the winners and losers will be.
The law of large numbers is the basis of all types of insurance, including health,
disability, auto, home and liability. This law of large numbers changes the impossibility
of predicting life events for one individual, to surprising accuracy for predicting life events
for a large group. Insurance companies are perhaps the best score keepers of all.
They know approximately how many houses will burn each year; how many deaths and
at what ages will occur, how many people will die in auto accidents over the 4th of July
holiday, and how many people will be permanently injured in job related accidents. If an
insurance company insures it, they know the statistics.
Insurance companies want to insure sufficient quantities of people to minimize their risk.
That brings in competition. It is important to each insurance company to bring in the
number of policies necessary to minimize their losses. To bring in sufficient quantities,
they must be competitive. This brings consumers better and wider choices.
Of course, statistics do eliminate risk for the insurance companies. It is impossible to
achieve an infinite number of exposure units, so there will always be some margin for
error. In addition, statistics are not perfect. It is possible to have wrong "facts.” It is
also possible to misread the available information or to have too little information for a
factual observance. An actuary was once quoted as saying that they initially had to
underwrite nursing home policies with a crystal ball. Why? They had too little
information available to know the outcome of their profits and losses
Since risk diminishes with larger numbers and insurance seems so logical a method,
one might wonder why all uncertainties are not combined in one big insurance pool to
virtually eliminate risk. Unfortunately, it is not quite that simple.
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In order for an insurance company to operate successfully, several things are needed:

A large group of homogeneous exposure units.

The loss produced by the peril must be definite.

The occurrence of the loss in individual cases must be accidental or fortuitous (not
purposely done, such as arson).

The potential loss must be large enough to actually cause a hardship.

The cost of the insurance must be within the means of large numbers of people

The chance of loss must be calculable.

The peril must be unlikely to produce loss to lots of people simultaneously.
Homogeneous Exposure Units
Let us look at these points individually. The first one, a large group of homogeneous
exposure units, means it is essential that a large number of exposures be similar, though
not necessarily identical. If there were not enough policyholders facing the same peril,
then not enough policies would be sold. If not enough were sold; the insurance
company could not offer premiums at a price that consumers would buy. In life
insurance policies, for example, many people are needed in differing age, health and
occupation classifications. This allows the insurance company to spread out their
potential risk. While some people will die and collect benefits, more will live to pay
additional premiums to the company.
Loss Produced By The Peril Must Be Definite
The second point, the loss produced by the peril must be definite, which means it must
be difficult to counterfeit. Death is probably the best peril because it is difficult to
counterfeit death (although it is sometimes attempted). As we know, it is common for
people to try to collect from insurance companies by fraudulent means. Disability
insurance is now subject to strict underwriting because of past problems with adverse
experience. In other words, they lost too much money to disability claims.
Occurrence of the Loss Must Be Accidental or Fortuitous
The third point, the occurrence of the loss must be accidental or fortuitous, means it
must be an accidental unexpected loss. The loss should be beyond the control of the
insured. Purposely setting fire to the insured’s' home is not unexpected. If the
homeowner sets a match to his or her house, he or she fully expects it to burn down!
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In some types of insurance, certain happenings are not covered because they are
considered anticipated losses. For example, under mercantile theft insurance,
shoplifting losses are not covered because they are considered part of the business;
they are anticipated losses. In credit insurance, bad debt losses are not covered; they
are anticipated losses for that line of business. Life insurance does not actually cover
death, because everyone is expected to die at some point. Rather, life insurance
covers premature death, because the exact point of death cannot be determined.
The Loss Must Be Large Enough To Actually Cause A Hardship
The fourth point, the loss must be large enough to actually cause a hardship, means the
loss must cause the insured economic stress. Some types of loss are simply too small
to be worth the time, effort and expense to set down an insurance contract. Remember
that every written policy had expense involved from the actuaries down to the selling
insurance agents. These expenses are reflected in the premium price. Obviously,
consumers are not likely to pay the cost of a premium that is potentially higher than the
actual loss would be. Even so, there are some types of coverage that is part of larger
policies that do cover small items. Small losses that could be absorbed are seldom a
worthwhile buy. Still, we see consumers buy such things as dread disease policies or
hospital indemnity policies because the premium is low.
Affordable Premium Costs
The fifth point, affordable premium costs, is necessary. If not enough consumers
purchase the insurance; the cost will not be low enough. If the cost is not low enough,
there will not be sufficient quantities of insured.
The Chance Of Loss Must Be Calculable
The sixth point, the chance of loss must be calculable, means the probabilities of loss
can be determined by logic or by a tabulation of experience. Most types of insurance
are determined empirically, which means by a tabulation of experience, which can be
projected into the future. If no statistics on the chance of loss are available, the ability to
accurately predict loss is low even if large numbers are available.
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The Peril Must Be Unlikely To Produce Loss To Many People Simultaneously
The final point, the peril must be unlikely to produce loss to many people simultaneously,
is not hard to understand. No insurer can afford to insure a loss that happens massively
at the same time, such as loss due to floods or volcanoes. Although everyone will die at
some point in time, insurers can still underwrite life insurance because it would be
unlikely that all of their policyholders would die simultaneously. War and acts of war,
which might cause large quantities of death at once, are not covered.
WOMEN – INVESTING & RISK
Studies have found that women in general are far more concerned with the fear of losing
money (risk) than the chance of gaining it (return). Women tend to blame themselves if
an investment loses money, whereas men will blame weak markets, bad advice, or bad
luck. Because of this fear of losing money, too many women put their savings into more
conservative, easy-to-understand investments—like savings accounts OR GIC type
investments.
Longer life expectancy equals larger earnings
The way your money may grow through compounding is the greatest single benefit a
long-term investment plan can offer you. When you invest, you not only have the
potential to earn money on what you've contributed, you also have the potential to earn
money on your earnings. This is especially important for women since they tend to live
longer and will need greater assets to rely upon in retirement. Compounding is one way
women can put their longer life expectancy to work for them.
Spread the Wealth
When it comes to investing, the old adage holds true—don't put all your eggs in one
basket. When your investments are diversified, or spread across different asset classes
or types of securities, they work together to help reduce risk. Mutual funds, which invest
in a broad range of different securities, are designed to be well-diversified investments.
Most investment experts recommend that individual investors combine growth-oriented
investments like stocks or stock funds with more stable, fixed-income investments like
bond and money market funds to help reduce risk and increase growth potential. Just
what balance works for you depends on your age, risk tolerance, and financial goals. A
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Financial Advisor can help you determine the right mix for your situation. Please
remember that diversification cannot eliminate the risk of fluctuating prices and uncertain
returns.
Stocks Versus Other Investments
While it's never a good idea to put all of your assets in the stock market, many women
tend to invest too little in stocks. You may end up with an investment plan that doesn't
offer the growth potential to meet your needs.
Keep in mind that you assume greater risks when you invest in stocks, and that past
performance is no guarantee of future results. Also, there is no guarantee that your
investment will increase in value. However, the benefits of investing in stocks may
outweigh the risks, especially since time is on your side.
INVESTMENT HABITS OF MEN VS. WOMEN
Here's an interesting point of debate: men and women differ in their approach to the
investment game and the difference is quite marked during the initial process. Research
has shown that men tend not to want too much detail while women want more
information. Women tend to really want to understand what's being suggested, and why.
A poll conducted in the late 1990s found that women spend 40% more time researching
a mutual fund before they invest. What's more, they tend to be less impulsive and less
inclined to act on a hot tip than men are. It also found women to be less confident in
their investing abilities than men. Only 56% of women feel confident about their
investing abilities versus 64% of men.
Another study looked at the investment records of 35,000 households with accounts at
local brokerage houses throughout most of the 1990s. The first finding was that men
traded more often than women. Men in the study group, on average, turned their
portfolios over by 6.4% each month (or 77% annually) while women turned their
portfolios over by 4.4% each month (53% annually). It also found that while both groups
would have done better by holding onto the stocks they had at the beginning of the year,
men tended to have lower returns at the end of the year than women.
Still another survey (but this one from the U.S.) tells of women doing better for
themselves than men when it came to money.
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The study of 1,000 men and an equal number of women found that 62% of the women
balanced the cheque book; 58% paid the bills. But when asked to make the investment
decisions, only 15% of the women said they alone had the sole responsibility. (Men
were apparently not asked.) 44% of the women indicated that they balanced a budget
themselves; only 23 % of the men did it.
A life insurance study indicated that only 1 in 9 widows will re-marry. This is important to
know because some men think they don't need much life insurance because they feel
that if they die their wife will re-marry. However, a single mom who is trying to hold
down a full time job to make ends meet, or an older spouse who has been a housewife
for many years, may not move in the right circles to find a new husband. On the other
hand, given the above study results on investment and budget skills, a widow who is left
a life insurance inheritance may be able to successfully manage her financial affairs if
she has enough money to work with and may not look to remarry.
If the above study results can be applied to the general population it would seem that
family units would do well to involve the female spouse both in investment and
succession planning.
TEN SELF-DEFENSE TIPS AGAINST INVESTMENT FRAUD
1. Don't be a "courtesy victim." Most individuals are taught to be courteous at all times
to phone callers, as well as to people who visit them at home. Con artists will not
hesitate to exploit the "good manners" of a potential victim. A stranger who calls and
asks for your money should be regarded with the utmost caution. You are under no
obligation to stay on the telephone with a stranger who wants your money. In these
circumstances, it is not impolite to state that you are not interested and simply hang
up the phone.
2. Check out strangers as well as their touted "deals." Say "no" to any investment
advisor or salesperson who presses you to make an immediate decision, preventing
you from checking out the person as well as the investment. Before you part with
your hard-earned savings, get written information about the investment opportunity,
review it carefully and make sure that you understand it before making any
decisions.
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A favourite tactic of telemarketing con artists is to develop a false bond of friendship
with older people. If you are dealing personally with a stockbroker or financial
planner, do not be swayed by offers of unrelated advice and assistance that are
merely efforts to develop a sense of friendship and even dependency.
3. Always stay in charge of your money. A stockbroker, financial planner or
telemarketing con artist who wants your money will be more than happy to assure
you that he or she can handle everything, thereby relieving you of the need to watch
over and protect your nest egg. Beware of any financial professional who suggests
putting your money into something you don't understand or who urges you to leave
everything in his or her hands.
Constant vigilance is a necessary part of being an investor. If you understand
little about the world of investments, take the time to educate yourself or involve a
family member or a professional, such as your banker, before trusting a stranger
who wants you to turn over your money and then sit back and wait for results.
4. Never judge a person's integrity by how they "sound." Many older people who get
wiped out by con artists later explain that the swindler "sounded like such a nice
young man or woman." Successful con artists sound extremely professional and
have the ability to make even the flimsiest investment deal sound as safe and sound
as putting money in the bank. Some swindlers combine professional-sounding sales
pitches with extremely polite manners, knowing that many older people are likely to
equate good manners with personal integrity. Remember that the sound of a voice
(particularly on the phone) has no bearing on the soundness of an investment
opportunity.
5. Watch out for salespeople who prey on your fears. Con artists know that many
retirees worry that they will either outlive their savings or see all of their financial
resources vanish overnight as the result of a catastrophic event. As a result, it is
common for swindlers and abusive salespeople to pitch their schemes as a way for
older people to build up their life savings to the point where such fears are no longer
necessary.
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Remember that fear and greed can cloud your judgment and leave you in a much
worse financial position. An investment that is right for you will make sense
because you understand it and feel comfortable with the degree of risk involved.
6. Exercise particular caution if you are an older woman with no experience handling
money. Ask a con artist to describe his ideal victim and you are likely to hear the
following two words: "elderly widow."
Sadly, many women who are now in their retirement years often received little or no
education in their youth about how to handle money. Women of this generation often
relied on their husbands to handle most or all major money decisions. As a result,
older women, and particularly those who have received windfall insurance payments
in the wake of the death of a spouse, are prime targets for con artists. Elderly women
who are on their own and have little know-how about handling money should seek the
advice of family members or a disinterested professional before deciding what to do
with their savings.
7. Monitor your investments and ask tough questions. Too many older people not only
trust unscrupulous investment professionals and outright con artists to make financial
decisions for them, but compound their error by failing to keep an eye on the
progress of the investment. Insist on regular written and oral reports. Look for signs
of excessive or unauthorized trading of your funds. Do not be swayed by
assurances that such practices are routine or in your best interests. Do not permit a
false sense of friendship or trust to keep you from demanding a return of your
savings. When you suspect that something is amiss and get unsatisfactory
explanations, call your provincial securities commission and make a complaint.
8. Look for trouble when trying to retrieve your principal or cash out your profits. Many
older people have little ongoing need for income from investments, while others need
returns that are paid out regularly in order to supplement limited incomes. If a
stockbroker, financial planner or other individual with whom you have invested stalls
you when you want to pull out your principal or even just your profits, you may have
uncovered someone who wants to cheat you. Since unscrupulous investment
promoters pocket the funds of their victims, they often go to great lengths to explain
why an investor's savings are not readily accessible.
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In many cases, they will pressure the investor to "roll over" non-existent "profits" into
new and even more alluring investments, thus further delaying the point at which the
fraud will be uncovered. If you are not investing in a vehicle with a fixed term, such as a
bond, you should be able to receive your funds or profits within a reasonable amount of
time.
9. Don't let embarrassment or fear keep you from reporting investment fraud or abuse.
Older people who fail to report that they have been victimized in financial schemes
often hesitate out of embarrassment or the fear that they will be judged incapable of
handling their own affairs. Some investors have indicated that they fear that their
victimization will be viewed as grounds for forced institutionalization in a nursing
home or other facility. Recognize that con artists know about such sensitivities and,
in fact, count on these fears preventing or delaying the point at which authorities are
notified of a scam. While it is true that most money lost to investment fraud is rarely
recovered beyond pennies on the dollar, there are also many cases in which older
people who recognize early on that they have been misled about an investment are
then able to recover some or all of their funds by being a "squeaky wheel." A good
resource for older people who fear that they have been victimized by a con artist is
the securities agency in the province in which they live.
10. Beware of "reload" scams. Younger people who are ripped off by swindlers are
fortunate to the extent that they have the opportunity to pick themselves up and
restore some or all of their losses through new earnings. However, most older
people are dealing with a finite amount of money that is unlikely to be replenished in
the event of fraud or abuse. The result is a panic that is well known to con artists,
who have developed schemes to take a "second bite" out of older individuals who
have already been victimized. Faced with a loss of funds, some elderly citizens will
go along with another scheme (allowing themselves to be reloaded, in effect) in
which the con artist promises to make good on the original funds that were lost ...
and possibly even generate new returns beyond those originally promised. Though
the desire here to make up lost financial ground is understandable, all too often the
result is that the unwary senior citizens lose whatever savings they have left in the
wake of the initial scam.
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CONCLUSION
All of us face risks every day. Some are larger risks than others, but they still exist.
Even though we face daily risks, most of us do not feel we are in danger. We expect
the auto fatality to happen to that mysterious "other person.” We try to be careful in our
homes to prevent loss from fire. We do not expect to be disabled and unable to work.
That does not mean that we cannot die in an auto accident, or have a house fire, or
become disabled. We just do not expect it to happen to us.
Few people really think about the risks in their lives and this is the way it should be. No
one could be productive if they were paralyzed by fear. Even so, most Canadians do
use insurance to minimize their risks. We also generally recognize some of the risks we
take in our investments. Recognizing risks and doing what can logically be done to
minimize them has become an accepted part of life. Although we may not realize it,
most Canadians are involved in risk management. The objective of risk management is
simple: minimize risk or transfer risk to another. Although we do not state it, our
purpose is to maximize productive efficiency by bringing about a balance between
financial resources and the possibility of a financial loss. We want a balance between
premium costs and the protection it offers.
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