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.