Monday, 2 December 2013

Risk Need - Figuring out how much risk you need to take

Risk is always part of investing but how much do you actually need to take? The last component of any investor's risk profile to go along with risk tolerance /attitude and risk capacity is the need to take risk. The illustration below from Vanguard's booklet Investment risk and financial advice shows that all three elements need to be accommodated and in sync.

Trade-offs must be made - Before addressing the question of how to figure out how much risk to take, we must widen the context a bit more to the other key variables about which the investor can make decisions and trade-offs. The diagram below by Rob Brown in Risk Tolerance Questionnaire Failure sums it up - choosing more of one element means more or less of one or more others.
He defines the six inter-twined elements as: 1) Spending - how much is desired / needed to be spent i.e. the financial goal; 2) Savings - how much is to be saved; 3) Timing - when is the spending or savings to occur; 4) Risk - how volatile is the investment portfolio; 5) Legacy - how much is to be left to heirs or a charity and 6) Surety - how certain of the outcome does one want to be. We believe that this diagram could be simplified since Legacy is just another form of spending and Surety is just a net result of all the various risks attached to investing, including volatility and many others. However, the principle remains the same and is very useful for making decisions.

No Single Optimal Solution - The key point is that a person must make trade-offs - a lower spending goal or a higher savings rate means less necessity to take on risk, or deferring a goal, such as delaying retirement, can mean less need for risk too. The result is that there is no cut and dried single optimal arrangement for any investor overall, or even any single goal and no single best portfolio allocation either. There are choices to be made.

Take on only as much risk as you need - It is simple and perhaps blindingly obvious to many readers but why should anyone invest in a portfolio that is riskier than need be? If a high savings rate is joined to modest spending plans, it may be possible to achieve those goals investing in tried and true GICs. Why bother with anything else if that is the case? On the other hand, ambitious spending goals with limited savings may require a very high rate of return, perhaps unrealistically high, and a portfolio whose chances of disappointing are high as well. How does one know what is realistic?

The past as an indicator of the future - Though past investment history is not at all guaranteed to repeat, it can be a very useful guide, especially in seeing the contrast between performance of different portfolio allocations over different time periods, varying through good or poor economic growth, high or low inflation, rising or falling interest rates, wars, recessions and the like. Fortunately, there are several free online resources that allow us to see what happened in the past.
1) FinaMetrica's Investment Risk and Return Guide and Reports for Canada - The Guide gives the breakdown of 11 portfolios ranging from Very Conservative to High Growth, containing a progressive mix of cash, two types of bonds and three types of stocks. The portfolios are realistic and could be purchased today using index ETFs. The downloadable pdf Reports of five pages for each portfolio describes investment outcomes in very informative tables and charts that really gives a sense of the risk involved for the data period covered of 1973 to 2012. An interesting unique feature is that the reports compare portfolio performance to GICs. Below is a sample image of some of what appears in the report for Portfolio 7 (60% equity, 40% fixed income). The 10-year result for an investment starting in 1973 was decidedly disappointing compared even to one starting in 2003. Recall that inflation raged in the 1970s and the bond holdings took a big hit. Do we want to bet that inflation will remain under control and interest rates won't rise a lot, which would again hit bonds hard?

2) StingyInvestor's Asset Mixer - This is an interactive tool that lets anyone enter their own portfolio allocation and time period, the year coverage varying from 1970, for the majority, to as late as 1992 for real return bonds (when they first came to market). It allows the investor to enter a pseudo-MER, in the "alpha" input cell, in contrast to FinaMetrica which used pure index data i.e. no return deduction for management fees and expenses. The results can also be shown in real after-inflation, or nominal terms. Unfortunately, there isn't a box to enter an annual contribution in the model, only an annual withdrawal, which will be useful for those looking at a post-retirement scenario. A screenshot of part of the results for an almost identical 60/40 portfolio to the FinaMetrica Portfolio 7 is below. An investor who had stayed invested for 40 years while rebalancing annually along the way would have done quite well.

3) Index Fund Advisors Index Calculator - This calculator is also inter-active and allows entering an initial lump sum or annual contributions, or withdrawals, and varying time periods, going all the way back to 1928. The IFA tool shows US data for US investors only but since Canada often parallels US markets, though not year by year, over the long term it has experienced close to the same growth. The screen image of the output for a roughly similar (the individual asset classes would be US-oriented) 60% equity 40% fixed income portfolio shows about the same total growth over 1973 to 2012. It's interesting that the US investor's portfolio dropped 28% in 2008, while the Canadian version, according to the Stingy output about, only fell 14%. Recall that during the crisis, the Canadian dollar fell sharply as the safe haven US dollar rose, thereby much limiting the drop in value of US assets when translated to Canadian dollars. Diversification helped!

By experimenting with different asset allocations, initial investment lump sums, savings/contribution rates and withdrawal rates, it's possible to work towards those trade-offs mentioned above. Those who are approaching a crucial point like a retirement date can contemplate what effect another worst case year could have and decide whether a recovery lasting a likely two years (2008 US investor) or seven years (1973 Canadian investor) would cause irreparable financial or emotional harm.

For the future, a big question is whether rates of return will at least match those of the past, or more precisely which past - the boom after 1983 or the decade after 1973 when every portfolio and even T-Bills gained almost zero return in real terms. To see what difference a lower rate of return would make to end values, try a lower than historic growth percentage in a simple calculator such as GetSmarterAboutMoney's RRSP Savings Calculator.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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