Is bungee jumping on your bucket list?
You may or may not relish the idea of hanging upside down on a bungee cable. If that’s too risky, would you be more comfortable circling through the air on a ferris wheel? These experiences are dramatically different. Which would you choose? Your choice will be indicative of your risk tolerance.
Many clichés are used in terms of risk and one’s philosophy related to risk-taking: “Nothing ventured, nothing gained”; “Go big or go home”; “Better safe than sorry”. Each of these expressions contains a bias, but risk is not inherently good or bad. Let’s start with the definition of risk tolerance according to the International Standards Organization (ISO).
Risk tolerance is the extent to which you are prepared to risk experiencing a less favourable outcome in the pursuit of a more favourable outcome. It is the point at which you are psychologically comfortable with the implications of your choices – the potential loss or gain.
Research suggests that tolerance for risk, as with other psychological traits, is determined by genetics (how you’re built) and also by your life experiences and current circumstances. There are five different categories of risk: physical, social, health, ethical, and financial. Your risk tolerance may be different in terms of your health compared to your finances, for example. Although relatively consistent, studies show that risk tolerance does change and should be retested periodically. At Fraser & Partners we have been implementing a three-year planning cycle. Optimal results appear to be achieved if you undertake a thorough review at the end of every three years and recommit to your life vision and financial strategy. This includes a reassessment of your risk tolerance. You may need to rework your strategy more frequently if you are experiencing major changes in your life. Otherwise, during the three-year planning cycle, specific reviews of your cash management, income tax, portfolio, insurance and/or estate plan should enable you to keep on track each year.
To encourage you to assess your risk tolerance, we have a questionnaire available for you to take online. Talk to your advisor about getting signed up to take it. The questionnaire, developed by an Australian firm, FinaMetrica, is used globally, with norms for each country or region including Canada. Because it is so well researched, we find that it can be used to reliably pinpoint the relationship between risk and your financial decision-making. From a strategic planning perspective, it is important to understand how much risk you can tolerate – how much is too little and how much is too much, and to clarify how this relates to your financial strategy.
You can consider risk from many different perspectives – short-term versus long-term, real versus perceived, myths versus historical evidence, uninformed versus calculated.
If you were to brainstorm all the risks that you might face, you could likely generate a long list. Some of these may be on your list.
- not living the life that you want for you and those important to you;
- outliving your money;
- not being able to pay your bills;
- not being able to take care of your children;
- getting hit by the bus as you cross the street;
- your bank going broke;
- having too much money and worrying about it all the time;
- losing your job;
- losing your money;
- having your identity stolen and fraudulent activity occurring in your bank accounts;
- failing a test;
- getting a traffic ticket;
- becoming unemployable because your job skills are obsolete;
- taking a new job;
- getting married;
- not having a medical doctor when you need one;
- running out of gasoline;
- owning bonds/bond funds when interest rates are going up;
- the value of your portfolio fluctuating with the ebb and flow of the financial markets;
- your internet service going down;
- losing your cell phone;
- owing too much money;
If we reorganized the above list into the five categories of risk, we could more readily address them. Themes would emerge and we could build a plan. Generally speaking, it is advisable to take steps to protect yourself against the risks that may be less probable but that would be the most devastating if they were to occur.
As we apply the life planning process, risk management is central to the discussion. Many simply think about the risk of the financial markets, especially after the previous decade during which we experienced a disproportionately high level of volatility. The global recession, brought on by the credit crisis in the US (housing bubble and excessive mortgage debt), was traumatic.
As you review your Risk Tolerance Report (FinaMetrica), please think in terms of life as an adventure and the challenge you have in designing your adventure. Understanding your risk tolerance helps you to clarify what really matters most to you. Every day is immeasurably more enjoyable when you know that you’re prepared for the uncertainty that is life!
Lately I’ve had a number of comments along these lines “How are my investments doing? I’m afraid to look with all the things going on in the US (debt ceiling debate, a very vocal Tea Party and other political shenanigans). If you are investing through F&P, you likely are invested in investment funds whose portfolio managers are active – those who outperform over the long haul because they do the research to find businesses that are different from those included in the index. “Active share”, the percentage of portfolio holdings that are different from the index, correlates with outperformance over the long-term. That’s a topic for another day!
To provide a context other than the 30-second sound bytes by the media, let’s look at the historical performance and the volatility (risk) of the key indices used to track trends in the financial markets.
You cannot control the markets. You can control how you invest your money.
As we build out the content of this website, we will provide more detailed information on portfolio design that you will be able to reference. With such an abundance of information available on the internet, it seems as if it is actually more difficult to maintain clarity in terms of your risk tolerance and your investment approach.
Below are the historical asset class returns that we are currently using when projecting returns of different portfolio mixes.
|Asset Class||Benchmark Index||Years||Historical Returns since Inception to December 31/12||Historical Volatility Risk|
|*Cash||91 Day T-Bill Index||63||3.34%||3.98%|
|*Short-Term Fixed Income||DEX CDN Short Term Bond Index||47||3.97%||4.97%|
|Fixed Income||DEX Universe Bond Index||63||5.97%||8.06%|
|Canadian Equities||S&P/TSX Composite Total Return Index||63||8.86%||17.03%|
|Canadian Small Cap Equities||S&P/TSX Small Cap Total Return Index||26||8.86%||23.84%|
|U.S. Equities||S&P 500 Composite Total Return Index CDN$||63||9.43%||15.95%|
|U.S. Small Cap Equities||Russell 2000 US Small Cap Index||34||9.61%||18.14%|
|International Equities||MSCI EAFE Total Return Index CDN$||41||8.02%||21.94%|
|Emerging Market Equities||MSCI Emerging Markets Index CDN$||25||12.00%||30.32%|
|Real Estate||S&P/TSX Capped REIT Index||63||8.93%||12.26%|
*These returns are built on an assumed forward-looking inflation rate of 3%. The asset classes for cash and short-term fixed income have been adjusted downward arbitrarily. The historical real return on cash has been reduced by 1.5% in light of historically low interest rates. Source: www.planplusplanit.com
In future blogs I’ll review the historical performance of different asset mixes or allocations relative to inflation. If you have any questions about the table above, call your advisor or make a note of the question and raise it when you have your next meeting.
The information in this commentary is for informational purposes only and not meant to be personalized investment advice. The content has been prepared by Jan Fraser, Life Aligned Investing of Aligned Capital Partners Inc. (ACPI) from sources believed to be accurate. The opinions expressed are those of the author and do not necessarily represent those of ACPI.