Investment risk comes from two sources

1. principal risk
   • loss of principal
   • a conservative investor wants to at least get back the original investment
2. inflation risk
   • loss of purchasing power
   • e.g., 4% GIC guarantees principal in return, but if inflation is 6%, the purchasing power drops

Six Factors Affecting Investment Returns

There are six factors that affect the returns on an investment

1. compound growth
2. general economic factors
3. guarantees on capital or returns
4. inflation
5. risk
6. tax-deferred growth

Compound Growth

• reinvestment of ongoing distributions (e.g., interest) → returns on the original investment and on the reinvested income

Tip: start young

General Economic Factors

• various global and national factors
  • e.g., water, supply of oil
• international business, stock market, world conditions
• taxation and government spending, money supply

Guarantees on Capital or Returns

Guaranteed

Nonguaranteed

• higher risk → higher returns
  • e.g., mutual funds, stocks, dividends, capital gains

Type of Return

The type of return (interest, dividends or capital gains) has an affect

• interest
  • often guaranteed at the outset
  • taxed at the marginal tax rate
• dividends
  • never guaranteed
  • a share of the profits earned by a corporation
  • distributed to shareholders on a prorata basis
  • paid at the discretion of the board of directors
  • preferential tax treatment on dividends from Canadian corporations
• capital gains
  • never guaranteed
  • arise when capital property is sold for more than the Adjusted Cost Base
  • capital losses
    • can be applied against capital gains
    • can be carried back three years or carried forward in definitely

Inflation

• erodes the real value of an investment
• real return = nominal return - inflation rate

Risk

• uncertainty of future returns
• risk = f(price volatility of one type of investment versus the price volatility of another investment or the overall market)
• volatility in the price of one security compared with another security or the stock market
• financial risks
  1. business risk: beyond the control of the business (e.g., competition)
  2. currency risk: changes in the foreign exchange rates can reduce returns
  3. default risk: interest, dividends or principal may not be paid or repaid as scheduled
  4. inflation risk: increases cause real returns to decrease
  5. interest rate risk: adverse changes could occur
  6. liquidity risk: difficulty in buying/selling investments at the desired time (or at a fair price)
  7. market/systematic risk: all assets in that class (e.g., stocks or bonds) may decline (can't reduce by diversifying)
  8. nonsystematic risk: as stock or sector may move against (contrary to) the market; may reduce by diversifying (e.g., index fund)
  9. political risk: government interference (e.g., nationalization, war, additional regulations)

Tax-deferred Growth

• ideally, investment growth is tax-free until withdrawals are made
• available with RRSPs, RRIFs, RESPs, universal life insurance