Mitigating Risk (Part 3)

In parts 1 and 2 we identified and analyzed a number of risks associated with achieving our long-term goals that pertain mostly to reaching some form of financial freedom.

Risks associated with income generation (employment or other forms of incoming revenue related to daily work) and as a  corollary, any savings after lifestyle expenses are covered, can be mitigated by various forms of insurance. We shall save this for a future blog, where we can draw on the expertise of a trusted professional or two. 

Suffice it to say that I have witnessed the success of some whole life insurance policies issued many years ago that are, today, looking very strong in the diversification of assets and reduction of taxes categories (retirement and estate planning). Never considered "cheap", but always worth considering in a long-term plan, especially when you are young and healthy (because you won't always be so and insurance gets significantly costlier as you age).

In order to grow our money (savings) beyond regular contributions after lifestyle costs, we are going to need annual returns better than the annual increases in those costs (inflation).

That puts all the pressure on our investment portfolios. So lets look a little closer at how we assess (evaluate) the risk in our investment portfolios:

Each security we own has a history of price movement. Larger moves in the price of that security, over time, can be measured to allow us to understand the role that the specific security will play as a function of the total portfolio given a certain amount of price appreciation or depreciation.

The measurement of price movement is referred to as the standard deviation away from its mean (average). So that a more volatile (historically) investment (asset / security / stock / bond) will have a greater standard deviation:

We can look at each of the individual components (the grey dots) of the portfolio, determine their standard deviation and equate that to the combined total portfolio (red dot), to tell us what we might anticipate would be a likely scenario (% movement) for a significant negative (or positive) event. 

This helps us to mitigate the downside risk to our portfolios: we know each of our clients exposure to risk and the potential fall in value should a major event occur. Last March was a significant event whereby the S&P 500 (for example) moved about 3 standard deviations (approx. 35%) lower over a very short period of time. In contrast, our balanced and diversified  60% equity / 40% fixed income client portfolios slipped by about 8% (depending on the composition of the portfolio) and the 40% equity / 60% fixed income client portfolios slipped by about 4%.

That is, my friends, by design. The less the portfolio goes down following a significant sell-off, the quicker the recovery and the sooner it gets back to growth mode and onward towards the average annual returns necessary to build toward long-term goals.

The evaluation of these downside risks allows us to ensure that we can create a combined portfolio best suited to mitigate them.

And as we always and transparently will offer up: historical returns are not a guarantee of future growth, but at High Rock we work darn hard (behind the scenes) to make sure that we get our clients the best possible risk adjusted returns. 

If your advisor cannot tell you what your risk profile is, they are not doing their job.

 Mitigating Risk (Part 2)

In Part 1 we identified 7 risks to achieving your financial goals. 

In Part 2,  let's analyze these risks:

1) Not having a steady stream of personal income. 

Whether we work for ourselves (highly recommended, but comes with perhaps more potential risks) or for someone else, establishing a stream of income is, especially in our early post-education days, vital to enabling us to start building our future wealth. Not having income will definitely delay our arrival at our goals because it, obviously, means it will hurt our ability to save.

2) Not generating any savings.

Pictures, they say, are worth a thousand words (below), but if you can begin early enough, the powers of compounding are going to be the "magic bean" that allows you to multiply and accelerate the growth of your wealth. Perhaps see my June 24 blog "New Financial Literacy Curriculum" specifically, Lesson 3: compounding.

But you definitely don't want to miss out on this opportunity to grow your savings and wealth:

The growth chart above is based on a rate of an annual average growth rate of 5.5% before fees, taxes and inflation and regular contributions of savings. Which means that your income has to be able to cover your cost of living and have some leftover for saving.

Which leads us into the next risk factor:

3) Not getting growth from your savings beyond the annual increase in your cost of living:

As I suggested in Part 1, bank or other financial institution GIC's and savings accounts are just not going to cut it. When our central banking institutions (The U.S. Federal Reserve, Bank of Canada, etc.) tell us that interest rates are going to remain at or close to zero until 2023, don't be expecting to get a whole lot more out of any financial institution who wants to use your money to lend to others (and make the spread for their shareholders) at somewhere between 2-5%. 

In other words, you will have to find ways of growing your money that will require greater levels of risk. A 90 day Government of Canada treasury bill is "risk free" (as a short-term obligation of the Canadian Government). Currently it pays about 0.15% before fees and taxes. Anything that pays more is going to have some level of risk attached to it. No wonder investors are jumping into the stock market with very little idea of how much risk they are actually exposing themselves to.

Therefore... Risk #4

4) Investment asset price depreciation.

Stock prices as a broad asset classification, over long periods of time, generally go up.

 U.S. Equity (S&P 500 stocks) have returned price appreciation of 128% since 2000, or an annual average of 6.4%. Add the average annual dividend yield over this time period and the total return has been around 7.6% annually.

But they can fluctuate wildly at times. Most of us were watching what happened in March of this year. When you see that kind of volatility, it can be rather disturbing.

However, the central banks have figured out how to entice us back in by making "safer" alternatives so unattractive that some believe that there is little other alternative (at the current time) than to be invested in stocks, driving stock prices to somewhat extreme levels.

However, with little or no economic growth expected until 2023 (from current levels) and corporate earnings likely to offer little growth, what is the true value for stocks? A very important question for investors. If they are overvalued at current levels, then there is the possibility of price devaluation in front of us. For some (with shorter time horizons for reaching their goals) that may be daunting and carry too much risk. So it ultimately becomes a function of  what your specific goals are and the time allotted for achieving them.

For those who need steady cash flow into their investment portfolios, there is risk there too.

5) Investment asset income interruption

Lower interest rates for longer periods of time will mean that safer methods of deriving cash flow for investment portfolios are going to be affected. Investors who need "yield" will have to look at other, potentially higher risk alternatives. In the bond market, the safest bonds, issued by the Canadian or U.S governments yield between 0.55% to 0.70% for 10 years. Investment grade corporate bonds (like banks, insurance and telecom companies) are 1.5% to 2%. It may require some further venturing into the higher yield, higher risk bond world. Preferred shares, with higher dividend payouts have been exceptionally volatile through this time. 

6) The costs associated with investing.

Fees, commissions, MER's (Mutual Fund Management Expenses) can all eat away at your long-term portfolio growth (eroding the magic of compounding effect) and make it more difficult to get to your end goals:

7) Taxation 

Taxes, in our lifetime and likely for generations to come are not going down following the staggering debts and deficits that have been created in response to the Covid pandemic. In fact, expect governments to try to find ways of further taxing the wealthy (non-registered assets and capital gains). We have to be prepared to face this risk in the accumulation of wealth.

So what do we do about all of this risk?

Stay tuned...

Mitigating Risk (Part 1)

 We all have goals. Take a minute to think about what your goals are. Usually, they are likely to be centred around what kind of lifestyle you want to have for you and your family over a certain period of time: your lifetime, at least, and perhaps the lifetimes of your children and grandchildren.

In order to make many of those goals happen, we are going to need some sort of financial freedom, where we are no longer dependent on someone else to provide us with our livelihood (i.e. an employer).

The standard way of getting to that financial freedom point is to build wealth. Save, invest, minimize the taxes that you have to pay and grow your wealth. Sounds so simple, right? Perhaps not so much when you throw all the uncertainties into the mix.

It is the uncertainties that create risk. 

What is at risk, in the end, is whether or not we will be able to achieve our goals. 

If we save our money for our future needs (goals) and stick it in a GIC at 1% (before taxes and costs eat up anywhere from 1/4 to 1/2 of the interest) and the annual increase in our cost of living is 2-2.5%, then the value of our savings, over time, will be eroding at an annual rate of somewhere between 1-2%. Friends that is not what your local bank advisor might call "safe": your future purchasing power eroding and your goals fading.

OK, point made, we need to find alternative ways to get growth in our money. So we turn to the world of investing to find assets that will help us get growth, better than that which is available in a "safe" bank GIC.

Just how do we do that? We either buy assets that have growth potential (for capital appreciation), we buy assets that will pay us income, or we put together a portfolio with a combination of both.

That brings another layer of risk: we are going to be now dependent on 1) prices for some of the assets that we have purchased going up 2) that the income that some produce to be continuous and as tax efficient as possible. Remember that interest income is taxable at your marginal rate. Dividend income is taxed more favourably (at close to half of your marginal rate) as are capital gains (at the moment).  Want to know more about your marginal tax rate... go here: https://www.canada.ca/en/revenue-agency/services/tax/individuals/frequently-asked-questions-individuals/canadian-income-tax-rates-individuals-current-previous-years.html

So we have identified a number of risks that may impact your ability to reach your goals:

1) not having a steady stream of personal income

2) not generating any savings

3) not getting growth from your savings beyond the annual increase in your cost of living

4) investment asset price depreciation

5) investment asset income interruption

6) the costs associated with investing

7) taxation

At High Rock, we manage risk first, so it is important to understand all the risks well, before setting out on a path to create a strategy to get you to your goals: with economic growth low or non-existent (and unemployment high),  it is paramount now, more than ever to manage those risks properly.

Our new clients are coming to us because they are frustrated with a one size fits all investment strategy. They are concerned that they don't have a tailored wealth management solution, are tired of overpaying and worried about their current advisor's conflicts of interest.

More to come...

 Confidence

I have written often about the key to economic growth being tied to consumer and business confidence: confidence leads growth (as in the chart above). While we have certainly bounced from the lows in both consumer confidence and economic growth following the pandemic lock-down, we are not going to see the same magnitude of bounce in the near future as Covid / Coronavirus uncertainty remains high. Our desires to get back to a closer to normal life (immediate gratification) may have to be tempered as well.

Angus Reid Institute released a Sept. 8 report titled Economic Outlook: Covid-19 stalls trend of growing financial optimism in Canada. I might suggest having a look, as it paints a more realistic picture than the one currently being painted by stock markets (which, as I suggested in my Aug. 31 blog, are in bubble territory).

In a nutshell, Canadians are underwhelmed by what they expect the future will bring:

The main story is employment recovery, which tracks very closely to consumer confidence (and that does not require any significant amount of imagination to understand): unemployed consumers, or even those who might be concerned about their employment in the future are not going to be spending much other than on their basic survival:

Something to keep in mind because Apple, Amazon, Microsoft, Facebook and Alphabet (Google) require consumers to be spending to support their businesses (and earnings) and it is the buying of those 5 stocks that has been driving markets higher (since the lows in March). Until now, government payments supporting unemployed workers has muted the long-term impact on economies, but that will not last forever and eventually, as we might say, the "rubber will meet the road".

We should also be wary of financial and other lending institutions where there have been deferred payments on loans and mortgages. When deferments cease, the repercussions on the unemployed could be disastrous for those companies.

Are people going back to their office towers? To the malls? Sporting events? Concerts? Vacations and cruises? Not likely in the near term and for many, only if the current virus is eliminated. That will take time (if it is possible to do so) and in the interim our impatience with waiting for it to happen will grow.

I know it is not easy to be patient in the current times of fast information flow and the need to be constantly visiting our devices for the latest updates and opinions, but unfortunately patience and a sense of caution will be part of the new normal, especially when we have limited places to go for our distractions. Best we all settle in for the long haul: focus on our long-term goals and keep some safe cash (or equivalent) on hand for opportunities if and when they develop.

 What Is An Investor To Do?

While I have stepped back from my blogs for most of August, I have still had the opportunity to have some excellent conversations with clients, prospective clients and non-clients who just want to understand financial markets (and what to do about them, if anything). The U.S. Federal Reserve (along with other global central banks) has, or at least is in the process of creating an asset price bubble as money continues to remain cheap and liquidity is sloshing around the global financial system. Could the bubble continue, certainly. As my good friend Dennis Gartman always reminded us in his daily market letter (which he retired from writing at the end of last year, see my final blog of 2019 Expect The Unexpected (Again)): of the Keynesian quote that "markets can remain irrational far longer than you and I can remain solvent". Stock prices (and home prices, for that matter) will continue going higher until they stop doing so. Whether it is the fear of missing out (FOMO) or that there is no alternative (TINA) which is driving the buyer emotions.

5 stocks are driving the S&P 500: 

And that has pushed the S&P 500 to new highs:

and a year to date price jump of 7.68% in the middle of a pandemic induced recession that could well last past 2022. Think 2030 perhaps? Unemployment is going to remain stubbornly high for a long time to come. The repercussions from that alone will be significant. Seems to be that it is not getting stock and house buyers down, however.

Just in case you were wondering how expensive stocks are:

So if you are feeling the pressure to jump into the feeding frenzy, my advice to you is to be patient. From the Fear and Greed index chart, over time, opportunity will once again present itself as it has in the past (March was a good opportunity), there were a couple of them in 2018 as well. Certainly, the moment is not now. If you have new cash on hand, park it for the time being.

Paul (who manages High Rock's Tactical Model) picked up the Sprott Physical Gold and Silver Trust (CEF) fund in late March / Early April, turned out to be an excellent addition. But this is not a recommendation to go out and make that fund purchase without first checking in with your advice giver on whether it may be appropriate for you. Point being, opportunities will return. Wait for them.

Our good friend David Rosenberg suggested in today's Early Morning With Dave that these are the assumptions that have been priced in to the financial markets (i.e. they are reflected in current pricing):

• That the policy stimulus will continue well into the recovery phase
• That there will be no economic relapse ahead
• That we are months away from a vaccine being developed
• That the erosion in U.S. - China relations is mere noise and more progress is coming on the trade front
• That Trump will end up winning the election on November 3rd.
• That the Fed will finally be successful at generating inflation.

 If you have not received an evite to High Rock Private Client's (belated and postponed) 5 year anniversary (now a) Zoom meeting featuring David Rosenberg as our guest speaker and wish to attend, let us know. 

"Hope For The Best, Prepare For The Worst"

That was a classic line that my canoeing partner would shout to me as we entered the white water on our paddling adventure down the great Missinaibi River of Northern Ontario (eventually flowing into James Bay, via the mighty Moose River) in 1980. It has stuck with me throughout my career managing risk (which began shortly thereafter) and in life and other subsequent canoeing adventures .

Yesterday, Federal Reserve Chairman Powell suggested the same: "

A text from my former canoeing partner this morning: "Ha! Chair Powell is listening".

The news on the economic front is not good. If the normally optimistic (they always want to inject a vision of economic confidence) U.S. Federal Reserve is planning for the worst, I think that anybody who takes risk (whether on their own or with the help of a professional) in financial markets, to grow their investments, ought to heed these words. 

When I think of the word "Hope", it reminds me of all the possible outcomes that I wish I had control over, but don't, so I am reduced to hoping. So while the overly optimistic stock market cheerleaders are hoping that they will convince more unsuspecting buyers to throw caution to the wind and jump in to the feeding frenzy (FOMO and TINA) for which there is a named

From the

And for emphasis, the Q2 US GDP (-32.9%) announcement was released this morning. It is more than just "white water" turbulence, it is indeed a waterfall. Add to that, that 1.43 million Americans filed unemployment claims in the week ending July 25 and the Q3 GDP data are beginning to look pretty soft. Covid-19 is definitely impacting the outlook. 

Once again, with persistent unemployment, consumer's (which account for about 2/3 of U.S. economic growth and slightly less in Canada) will not be driving economic growth.

The unemployed cannot borrow (banks will not lend to them) at record low interest rates. So regardless of how investors perceive the Fed's ability to back-stop financial markets and /or economic growth, they cannot force lending to those who are not creditworthy (unemployed). When the period of mortgage deferrals ends (1 in 5 Canadians have been utilizing this), there may be some reckoning for overly indebted households, putting further pressure on banks and the housing market.

The current state of the stock market these days (currently decoupled from economic reality) is tending to be driven by the need for instant gratification (day trading / gambling), which could, as traders become more anxious about a lack of upside momentum (valuations are very stretched), bring about an exodus that may in turn bring about a return to reality and a focus on the medium term that the Fed has suggested is fraught with uncertainty.

For this, we shall be prepared.

Different and Better

Paul and I started our High Rock journey together with one very specific goal in mind: we wanted to create a unique wealth and investment management company that would give our clients a better experience than they would get with the larger more traditional investment advice operations.

1) Tailored portfolio management based on your specific end goals.

2) Fiduciary duty, with no conflicts of interest. 

We are not paid in commissions or by mutual fund trailer fees as a function of "gathering" assets (like most advisors). We earn a salary. If High Rock is successful (i.e. we do a good job for our clients) we can receive dividends based on our ownership of the company. 

We own the exact same investments as our clients (although the % allocation might be different, depending on our respective investment strategies).

3) Our fees are completely transparent (and tax deductible in your non-registered accounts).

As is often the case, I was chatting with a new prospective client the other day who, while trusting his former advisor to do the right thing, had uncovered the fact that there had been some serious "gouging" on fees and costs over the past several years. A shame because those costs, compounded over time can add up significantly.

The first High Rock blog that I ever penned way back in April of 2015 was about this very subject: What Are You Paying For Financial Advice?

 4) We manage risk first: all our investments have a certain level of risk and this risk is quantified (based on historical price movements over time, known in statistical circles as a standard deviation). Through this we can determine what risk any client portfolio is carrying and determine its vulnerability to a major downside move (like the one that we experienced last March) and adjust it accordingly, if necessary. We can also determine how our portfolios perform on a return per unit of risk taken measurement:

Over time, our client in the above chart has earned a return per unit of risk taken over the last 7 3/4 years better than any of the associated benchmarks. If you are not our client, has your advisor ever shown you your return per unit of risk taken? This is in fact different. And better!

As you all know, but may not necessarily get told, past performance is not a guarantee of future returns. However, at High Rock (as all of our existing clients know and recently experienced) we work darn hard to make sure that we do get the best possible risk-adjusted returns as we can.

5) Our custodian, Raymond James Correspondent Services, holds our client accounts (and the assets in them) and with that gives you all the protections that you would get at any major financial institution: Canadian Investor Protection Fund (CIPF)  

If you are not a client and would like to investigate further, let me know: scott@highrockcapital.ca

Our existing clients have been introducing us to some of their less than happy friends and family who have not had such good experiences with their investments of late.

We started out on this journey to make a difference. I and obviously our clients (who are sending us new introductions) think we have done a fine job of doing so!

Our Covid postponed 5th Anniversary event with special guest speaker and renowned economic and market strategist David Rosenberg will be now held as a Zoom meeting. Let me know if you would like to attend.