Understanding Your Investment Goals and Risk Tolerances
Two of the first questions that an investment advisor must (by law) ask each
new client, is " What are your investment goals" and "What is your risk
tolerance"?
These seem like simple questions. In reality they are both very complex
questions. The vast majority of investors have never really thought through
their goals or risk tolerances and they are in no position to provide well
thought out answers to these questions.
For investors who are still in the working and saving phase of their life,
the first reaction that often comes to mind as a goal is "to accumulate as much
money as humanly possible by retirement age". However while very attractive, this
goal is usually too simplistic and fails to take into account exactly how and
when you might spend this nest egg.
Investors need to have well thought out goals because your investment goals
(and not your sleeping patterns) should
directly determine how much risk you can afford to take and therefore how your
money should be allocated between stocks, bonds, cash and other asset classes.
Risk tolerance is often approached as if it is simply a matter of individual
preference. In reality it should be approached as a question of tolerance, not
preferance.
Higher risk over long period of times is strongly correlated with higher returns
but it is not a guarantee. Risk tolerance is mostly determined by how soon the
invested money is needed for spending and what the consequences are if the
investment declines in value due to risk.
Money that is needed for next year's groceries should not be put at risk even
if the investor psychologically loves to gamble.
I recommend that investors first think about when they will need the money
and what are the consequences of not having the money when needed before
deciding on their investment goals and risk tolerance. The typical investment
process can be broken down into a number of levels that may be attained over a
lifetime.
Level 1 - Emergency Fund
Every working investor should consider setting aside a certain amount as an
emergency fund. This money should be outside of an RRSP and should be in low
risk cash or short term investments and definitely should not be in an
investment that you cannot or would not want to liquidate as soon as required.
My view is that this fund is not needed to pay for things like an
unexpected medical expense or a new roof on the house. Those expenses can be
handled through a line of credit. The reason an emergency fund is needed is that
almost all workers are at least somewhat vulnerable to sudden job loss. If you
lose your job you won't want to use a line of credit for living expenses as this
would drive your stress levels through the roof. If you expect a severance on
job loss, you still need the emergency fund since it may take several months or
more to negotiate and receive your severance settlement. An emergency cash fund
will allow you to comfortably take your time and negotiate a reasonable
severance settlement.
Two income families could forego the cash emergency fund if they can get by
on one salary. Also if you think your job security is iron-clad then perhaps you
don't need an emergency fund.
Level 2 - Long Term Contingency
Every investor should consider that there is at least a small chance of
becoming totally and permanently disabled. Many Canadians have little or no
disability insurance, particularly against disability caused by illness. This is perhaps best handled by purchasing disability
insurance. But this insurance (except through certain employee group plans) is
quite expensive.
Unlikely but possible contingencies can also include getting involved with an
expensive legal battle or an expensive divorce situation.
Even though you may have a very long term time horizon for your investments,
there is always some chance that something major and unexpected will happen and
you will need to dip into your long term savings. This is one of the reasons
that most investors should not lock up all of their investments in stocks since
there is always a chance that you will need to access cash quickly, and you
would not want to be forced to sell stocks at an inopportune time.
Level 3 - Sustenance in Retirement
Almost all investors should have as a major goal, the maintenance of a
reasonable minimum life style in retirement.
A 100% stocks strategy has the best chance of making you really rich
but also has some small chance of leaving you with a completely inadequate
lifestyle, so you need to think very seriously before you choose a 100% stock
allocation. If you go 100% stocks, the percentages are on your side and you will
probably win in the long run. But you only have one life to live and even though
the risk is small you don't necessarily want to risk living in poverty when you
could have locked in at least a minimally comfortable lifestyle with a more
balanced - and lower risk - allocation.
We all buy fire insurance on our houses even though it is extremely unlikely
that our house will ever burn. It is this same rationale that would cause us to
give up some of the potential up-side from stocks and invest some money in safer
assets in order eliminate the remote chance of poverty in old age that could be
caused if stocks tank for decades.
Anyone not eligible for CPP should take this sustenance requirement most
seriously.
Similarly, those without good pension plans need to be careful to insure they
can fund an adequate lifestyle a even if the stock market tanks for decades.
Thos who are eligible for full CPP, old age pension and a good employer
pension may be able to ignore this sustenance level completely. With an adequate
level of comfort already assured, these investors can afford to go for the gusto
and could consider a much higher stock allocation in their investments.
Level 4 - Upper Middle Class Comfort and Freedom in Retirement
Once investors have assured themselves of an acceptable sustenance level in
retirement, the next step is to save for and ultimately lock in a reasonable
level of comfort and freedom.
This would include the ability to travel somewhat and perhaps to spend a
month or two in southern climes each year. This would equate to an upper middle
class lifestyle maintained throughout retirement.
Level 5 - Real Wealth
Investors reaching this stage probably have the equivalent of at least
$2 to 3 million in wealth (including the value of CPP and all pension plans,
which are often well over $1 million) as they enter
retirement.
This will fund a fairly luxurious lifestyle.
It also allows for a large estate to be passed on to offspring or a favorite
charity.
For most investors this would require an aggressive approach with a very
significant allocation to stocks combined with heavy savings for many years. It
may also be funded through ownership of a very successful business.
DISCUSSION
I believe that most younger investors would like to get to Level 5 or at
least to Level 4.
But just because we want to get to level 5 does not mean that we should be
overly aggressive with our entire portfolios.
My view is that we should mentally (or physically) segregate our investments
and lock in each Level one at a time before moving on to the next level.
Many of us are muddling along sort of working on all the levels at once, and
not really approaching the problem rationally.
For example, some investors (think ENRON employees) did very well on tech
stocks and were well on their way to securing a Level 5 scenario. But they
failed to set aside a sufficient portion of their funds to lock in Level 4 or
even Level 3. In the most extreme cases they now face a a struggle for much
beyond bare sustenance in retirement when they could have easily locked in an upper
middle class lifestyle - for the rest of their lives. And they did this by
chasing extra dollars in the Level 5 scenario that would not really have changed
their lifestyle much at all, at that point.
As investors accumulate enough to fund each level they should then focus on
capital preservation to lock in each level.
A typical scenario would be the following:
In the 20's to mid 30's pay off any student loans and accumulate a 3 month
emergency fund. Keep this fund invested in cash and money markets permanently.
Forget about RRSP contributions until this is done. The RRSP "room" will
probably be worth more to you later as your salary increases.
Next begin maximizing RRSP contributions. With any extra cash, pay down the
mortgage. At this stage I suggest being fairly aggressive with a heavy or even
100% allocation to equities to achieve the highest probable returns. Some
portion might be kept in cash in respect of Level 2 the need for sudden
contingency money on a longer term basis.
Completing Level 3 to insure sustenance in retirement could take several
decades and depends heavily on the existence of a pension plan. As Level 3
becomes more assured begin to focus on locking in this layer of your retirement
money by moving increasingly into shorter term bonds and away from equities.
About 25% might be permanently left in equities in order to protect against inflation.
Those with good pension plans and very secure jobs may consider moving
directly to Level 4. In this case the mortgage should probably be paid off first
in odder to be more sure that Level 3 is in fact locked in.
By the time the mortgage is paid you may have locked in Level 3 and you are
moving into funding Level 4.
Often Level 4 may involve investing outside of the RRSP. At this point much
of the RRSP has moved into fixed income investments to lock in Level 3 and the
non-registered plan should focus on a large allocation to equities and can be
more aggressive.
After another decade or so, Level 4 may be assured. As Level 4 becomes
assured it is logical to lock in this level by focusing on capital preservation
and moving away from riskier investments and into more fixed income, leaving
perhaps 25% in equities to protect against inflation.
Eventually, some investors can completely lock in level 4 and finally begin
working aggressively on Level 5, safe in the knowledge that at a minimum they
have already locked in an upper middle class lifestyle for life. Even the oldest
investoirs may keep a large portion of their "Level 5" investment in equities
since the time span for spending this money may be after their ultimate deaths
and since they don't depend on this money for their lifestyle.
Conclusion
It is no wonder that investors don't give logical answers when asked about
their investment goals and risk tolerances or preferences. First they have not
really thought about it. Secondly, it is not really a logical question, as posed.
Investments should be thought about in layers. No investor should claim to
ignore capital preservation in favor of maximum (probable but risky) capital
growth. Instead each investor should have different goals and risk tolerances
appropriate for each level.
The above scenario is not a totally clear-cut path. For example, each
investor has to discuss with their advisor how much money is needed to reach
each Level threshold. And this will likely change as the investor's salary and
time horizon changes.
But thinking about your investment goals in terms of these successive levels
should add to your clarity of thinking. Rather than being overly conservative or
two aggressive, you can think about how much money you NEED to be conservative
with in order to lock in sustenance, comfort, or relative luxury, depending on
your own situation, and then how much is left with which you can afford to be
much more aggressive.
February 14, 2003
Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.
www.investorsfriend.com