Smart Risk

The Consumer Price Index rose by 1.9% in 2017. That's what we are told by Statistics Canada, based on their estimation of what the average household consumes.

As I say every time I write about this data, each household will have a different set of circumstances depending on what you consume and where you consume it.

Apparently it was cheaper to live in Ontario in 2017 (+1.5%) and more expensive to live in Saskatchewan (+3.4%).

Transportation, Shelter (Natural Gas prices) and Restaurant Food appear to be the key drivers of prices over 2017.

When the more volatile Food and Energy components are removed, however, the "core" rate of inflation rose at a more modest rate of 1.2%. 

The Bank of Canada (Central Bank of the Year), whose sole mandate is to maintain stable prices, likes to remove the more volatile components to see how the other (less volatile) components are fairing sees something from 1.6-1.9%.

They do expect higher inflation in the future, but have been suggesting that for over a year now. The longer term averages for total CPI have been in the vicinity of 1.6% over the last several years.

So what is important?

For your household, the most important issue for projecting wealth is the forecast for your cost of living: income less expenses will determine your ability to save.

Growing your savings at a rate at or above the future cost of living is the only way you can maintain your purchasing power in the future (real growth).

That makes the assumption of inflating your cost of living a very major input into the forecast of your wealth. Few folks take the time to truly consider the implications of this.

Currently, you can buy a Government of Canada 90 day T-bill for about 1.2% (the interest on that is fully taxable as income at your marginal rate), which is the least risky investment possible.

But if your cost of living is rising at an annualized rate of closer to 2%, that is certainly not going to cover it. So in order to stay ahead of inflation, you need to take some risk.

How much risk do you need to take?

It depends on what annual average return you want to achieve. It is all relative: history over the last 10 or so year cycle (top to bottom and back to top of the current market/economic cycle) suggests that a portfolio balanced with  a 60% diversified global equity ETF and 40% of a Canadian Bond Index ETF will give you something near 5.5%. The risk factor, the ability of this portfolio to swing up or down from its average (standard deviation from the mean), is about 5.5 as well. That means that the return per unit of risk taken is about 1. In essence you may get a year of 10% growth, but you may also have to put up with a year of 0% growth from time to time as well. We all love the former (exciting stuff), but we do not love the latter (scary stuff). 

You can find ways to avoid the swing potential (volatility) by reducing the risk factor (and increasing the return per unit of risk). That is what we do at High Rock. That is why our clients pay us a fee. We manage the risk so as to (as best as is possible) avoid the swings, which over the long term will enhance portfolio growth (ultimately less portfolio downtime from which to recover).

When equity markets are rising in price, risk is also rising (risk that lower prices will follow, inevitably), risk that may not necessarily be in your best interest. Managing risk then becomes essential.

You do have to take risk to beat inflation. Taking smart risk is the only way to do so.