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Defining risks
By Elliott Levine
Reducing risk exposure in your portfolio means more than diversifying assets and investing in different markets
Illustration: John Sapsford
The recent trend of investors selling their financial products and turning them into fixed income instruments reflect general nervousness about the volatility of the equity markets. Although most investors who adopt this strategy may be attempting to mitigate equity exposure, they may in fact be increasing their overall level of risk.
Risk is commonly viewed as the volatility associated with fluctuations in a portfolio's value - that is, the movement of the markets and the implications on portfolio performance. Most investors fear that market volatility drives portfolio values down. However, risk must be examined not only by looking at portfolio volatility but also by assessing systematic and unsystematic risk, inflation risk, return sensitivity, time and portfolio allocation adjustments due to life span.
Systematic risk relates to volatility due to a particular market or economy. Examples include the rise of Canadian interest rates in the 1980s or the oil boycott of the United States in the 1970s. Unsystematic risk relates to volatility due to a particular security - for example, the unanticipated lawsuits against Dow Corning or the fraudulent activities of Bre-X, and the associated detrimental consequences to their stock prices.
| Exhibit 1 |
|
THE EFFECT OF RETURN VARIANCE ON PORTFOLIO VALUE |
| 000 |
000 |
Portfolio value |
|
Starting |
Total investment |
Annual rate of return |
|
age |
($13,500/yr. to age 65) |
8% |
10% |
12% |
|
30 |
$472,500 |
$2,326,276 |
$3,658,800 |
$5,827,450 |
Investors can manage systematic and unsystematic risk through portfolio diversification. Diversifying by geography reduces market-related systematic risk by dividing the investor's portfolio across many different economies. Diversifying by maintaining a large number of securities (the concept of a mutual fund) minimizes unsystematic risk by reducing an investor's exposure to issues related to specific companies. Most investors manage their systematic and unsystematic risk with relative ease. Reducing risk exposure does not, however, mean simply managing your portfolio's global exposure and your asset diversification. Risk management and portfolio allocation must also account for inflation, time and return sensitivity.
One strategy for managing the systematic risk of an RSP is to boost your foreign content level above the 20% foreign content restriction. Most mutual fund companies now offer clone funds - a relatively new concept - which are registered as Canadian content but whose performance is tied to international investments.
Inflation
In creating a financial plan, most investors neglect to consider the eroding power of the dollar. For example, in 1945 it cost four cents to mail a letter; today, it costs 46 cents. So the effect of inflation on future purchasing power is a risk no investor can avoid. Since 1950, the Consumer Price Index, the common measurement of inflation, has increased an average of 4.1% per year, thereby impacting a portfolio's real rate of return. In order to protect themselves, investors must understand that the real rate of return is the investment rate of return, less inflation. For example, assuming a portfolio with an 8% rate of return and a 4.1% inflation rate, the real rate of return is only 3.7%. A conclusion as to whether or not a 3.7% rate of return is acceptable may be drawn only after assessing the risks associated with achieving a higher rate of return.
Let's compare income required at retirement in a zero-inflation environment versus an average inflation environment. Say a 30-year-old wants to retire at age 65. He or she is earning $75,000 a year, which grows at a rate matching average inflation (4.1%).
Assume the 30-year-old's desired retirement income to maintain current lifestyle is 75% of current income. That's $56,250 per year in a zero-inflation environment. But in an average inflation environment (4.1%), the 30-year-old must plan for an annual retirement allowance of $187,800 - a difference of $131,550 per year. Although most consumers today live in a low inflation environment, it was only a decade ago that the inflation rate was far greater. It is imperative that investors protect their portfolios from the effects of inflation and the dollar's erosion, both during the earning years and in retirement.
Portfolio allocation
Most investors want to retire in their 50s or 60s and, entering that phase, they often seek safer investments. The average life expectancy of a male is 75 and a female is 81. Assuming an average retirement age of 65, most will spend 10-20 years in retirement. A common fear for senior investors is that they will run out of money, and, although they want to leave a legacy to children or grandchildren, discussions about estate and tax planning often reveal that most have not considered the tax consequences of death upon their estate. Improper portfolio allocation and / or ignoring the effects of inflation on a portfolio during the retirement years may result in running out of money too early. Asset allocation should include assets that have a higher expected return after inflation. Even the retired need some equities.
Exhibit 1 demonstrates varying rates of return on portfolio value. It shows the value of a portfolio of a 30-year-old who annually contributes $13,500 to an RSP until age 65. Assuming a rate of return of 8% to 12%, there is wide variance on the value of the portfolio at retirement.
Exhibit 1 shows that the difference between 2% and 4% on the portfolio value is significant. A 4% difference (from 8% to 12%) in rate of return results in a more than $3 million difference in the portfolio's value at retirement, thereby demonstrating the implications of portfolio allocation.
Investing is more an art than it is a science. It requires patience, discipline and, most important, a plan. Investing is not and can never be, an emotional exercise. Far too often, investors make short-term decisions as they get nervous, and so their investment choices become emotional and irrational. Portfolio allocation must be determined by examining the risk tolerance of a client; however, as has been demonstrated, returns vary.
Timing
Undisciplined investors who move their investments in times of uncertainty often make costly decisions. Often referred to as market timing, investors attempt to time the market by trying to purchase when the market is low and sell when the market is high (see Exhibit 2).
| Exhibit 3 |
|
THE EFFECT OF STARTING A RETIREMENT PLAN AT DIFFERENT AGES |
| Starting age |
Total investment ($13,500/yr. to age 65) |
Portfolio value at age 65 (8% rate of return) |
30
40
50 |
472,500
337,500
202,500 |
2,326,276
986,930
366,553 |
Most people begin working in their late 20s or early 30s and follow a similar life cycle. At the start of their working careers, most get married and have children. During this beginning phase, some decide that saving for retirement is not a priority. But this decision may be costly. Exhibit 3 shows how important it is to start early. Assuming an annual investment of $13,500 to age 65 with an annual rate of return of 8%, the implications of different starting ages is pronounced.
Though the investment difference between starting retirement saving at age 30 and starting at 40 is only $135,000, the difference in capital at retirement is about $1.5 million.
A well-thought-out financial plan is not simply a one-dimensional exercise. When making investment planning decisions, one must examine the implications of those decisions today and into the future. Risk incorporates the types of securities owned, the purchasing power for which those securities will ultimately be used, portfolio allocation throughout one's lifetime, greed or hesitation and market timing, as well as the implications of when to start investing. Investing is not, and cannot ever be, an emotional exercise.
Elliott Levine, MBA, CFP, is a director and financial planner at Levine Financial Group in Toronto.
Technical Editor: Ian Davidson, MBA, CFP, CA, Assante Capital Management Limited, Toronto.
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