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At its heart, investing is about risk, and stacking the odds in your favour

is president of Steadyhand Investment Funds Inc. tbradley@steadyhand.com

During the RRSP season we were barraged with ads from the banks and insurance companies. In light of the recent market turbulence, the emphasis has been on their 'risk free' products, such as index-linked notes and principal protected notes (PPNs).

These products, and others like them, guarantee that the buyers will get their money back, even if markets prove to be difficult.

I mention this because these products expose a serious divide between the professional investor and the amateur. Let me explain.

I've been at this gig for 25 long and weary years (which is also the way Lori describes our marriage). On every one of those days, I go to the office in search of one thing. An asymmetric bet.

In other words, an investment or business strategy where, in my judgment, there is limited downside if it doesn't work, and big upside if it does. That is an investment manager's Holy Grail.

In searching for such a situation, you won't see an investment professional buying a 'risk-free' investment, other than a government bond. That's because 'risk-free' or principal protected securities, are an asymmetric bet in the wrong direction. The odds are stacked against the purchaser.

Over the term of these risk-free products (usually five years or longer), the chances of losing money on the underlying investments (stocks, mutual funds, indexes) varies from nil to remote.

I would put balanced or income-oriented products in the category of having no chance of losing money. For terms of five years or more, I would put equity funds or indexes in the category of having a 'remote' chance of losing money.

Over the last forty years, there has only been one period (ending December, 1974) when the S&P/TSX composite index had a negative five-year return (-1.4 per cent). Over the same period, there were no seven-year periods in negative territory.

The other side of capital protection is the cost, and the costs of PPNs are high. The higher in fees, the less money that is available to you the investor. While the loss protection is unlikely to be of value, reduced returns are guaranteed and may be substantial.

In a recent Steadyhand blog, my partner Scott Ronalds went through the math. Some of the banks were running ads that show off the returns of recently matured index-linked notes, which on the surface look pretty attractive. In the fine print, however, you discover that the cost of downside protection was a 40-per-cent lower return. If investors had bought the index return through an exchange-traded fund (ETF), which includes dividends, their return would have been that much higher.

It is not my intention to use hindsight to pick on one particular product. Investment strategies are all about a variety of possible outcomes. Unfortunately, very few of those outcomes in a packaged 'risk-free' investment favour the buyer. The reward/risk profile of a PPN - a slight chance of avoiding a small loss versus the certainty of lower returns, perhaps substantially lower - is the opposite of what a professional is looking for. Which leads me to my main point.

Investing is about taking risk. Being thoughtful about it. Prudent. And stacking the odds in your favour when you can. Risk is the fuel that drives a portfolio. It must be present to generate returns in excess of the risk-free rate, namely Government bonds.

Tony Gage, my old partner at Phillips, Hager & North (he is older than me), used to talk about the four types of risk, all of which investors should have some exposure to.

The first two relate to his favourite pastime - bonds. Interest rate risk means owning longer-term fixed-income securities. They are more sensitive to interest rate changes, and therefore are more volatile than short-term issues, but you are rewarded with a higher yield.

The second is credit risk, which refers to the possibility that a borrower (i.e. the corporation issuing the bond) will not be able to pay back the loan. The riskier the borrower is perceived to be, the higher the yield.

The third is liquidity risk. It is usually forgotten, but often provides the best reward/risk opportunity. You are taking advantage of this type of risk if you invest in a security that doesn't trade regularly, such as a mortgage, private company or private equity fund. In purchasing a less liquid investment, you expect to be rewarded with a higher return.

Finally, the fourth risk is the one everybody focuses on - equity risk.

There is a wonderful piece written by François Sicart, the chairman of Tocqueville Asset Management in New York, in which he describes his unbreakable rule. He says, "I never invest in a situation in which I cannot lose money."

It's unlikely Mr. Gage and Mr. Sicart own packaged 'risk-free' products and it's unlikely your financial adviser or portfolio manager does either. If you ask, they should tell you that they are investors and investing is about taking risk to generate higher long-term returns.

So while principal protected products were a big sales winner this RRSP season, they are not showing up in the portfolios of people in the industry. That's because on this side of the divide, we're too busy looking for asymmetric bets that are in our favour.

© 2007 The Globe and Mail. All rights reserved.

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