360 Private Wealth Management's Natural Wealth Process: Portfolio Risk - Part 2
In our last blog, we attempted to frame the discussion on Portfolio Risk by trying to define and differentiate between risk (the possibility of permanent loss of investment capital) and volatility (the degree to which an asset price will fluctuate from its mean or average price).
The single best way to reduce overall portfolio risk and volatility is diversification, i.e. spreading our investment dollars between equities, fixed income assets and cash. You can further reduce risk and volatility by allocating investment dollars among a number of different investments within each asset class. For example, when investing in equities, owning shares in many companies that operate in different economic sectors in different parts of the world. It is generally accepted in most academic circles that asset allocation is often more important than which actual securities we invest in, as long as we are adequately diversified within each asset class.
However, if creating absolute financial wealth is a primary motivation, then a household must consider focusing their investments by investing in property or by starting / buying a business. The fact is that a short focused portfolio of stocks, rental real estate, or family-owned business can be a legitimate approach to creating and building wealth. The “cold water” reality check of this approach to building financial wealth is that it comes with a higher risk of actual capital loss. A concentrated stock portfolio, no matter how well researched, is subject to the impact of unforeseen circumstances. Unplanned expenses and increasing family businesses are subject to even higher risk given the dynamic nature of business and an individual family’s ability to handle the various challenges faced by a business over time. It takes a particular personality to handle the volatility of a concentrated stock portfolio or to start and operate a business enterprise. Not everyone is able to handle the stress associated with such an approach.
For our discussion we will focus here on investing in financial assets such as cash, bonds and stocks. The following table (courtesy of FinaMetrica) sets out the experience of various investment portfolios that may be owned by a Canadian investor, moving from a portfolio that is 100% invested in defensive assets (cash and bonds) through to a portfolio that is 100% invested in growth assets (a blend of Canadian, U.S. and International stocks), for the 10-year period ended December 31, 2017. For a definition as to how the portfolios were derived, you can refer to the 25-Question Risk and Return Report discussion for Canada on the FinaMetrica website under the heading Risk and Return Report (Click on 25-Question and then Canada; specifically pages 3 and 4 of the report). Note that the rates of return stated are gross of any fees and expenses that may be incurred and are for discussion purposes only. They are not indicative of any results that may have been experienced by any specific portfolio in the past or which may be achieved by a similar portfolio in the future. They are for discussion purposes only.
Rises, Falls and Returns (Canada) | |||||||||||
| Worst Fall | -6.2% | -5.3% | -8.8% | -13.0% | -16.7% | -20.6% | -24.0% | -28.10% | -33.1% | -37.8% | -42.6% |
| Best Rise | 28.9% | 24.4% | 33.1% | 34.7% | 35.7% | 38.3% | 36.7% | 32.9% | 37.1% | 40.2% | 41.9% |
| Multiple of Rate From GICs | 1.91 | 2.00 | 2.11 | 2.18 | 2.20 | 2.28 | 2.29 | 2.30 | 2.32 | 2.35 | 2.34 |
| 10 Yrs Real Annualised Return | 4.7% | 5.0% | 5.4% | 5.8% | 6.0% | 6.3% | 6.5% | 6.6% | 6.8% | 7.0% | 7.1% |
| 10 Yrs Real End Value of $1,000 | $1,623 | $1,652 | $1,735 | $1,805 | $1,856 | $1,917 | $1,945 | $1,969 | $2,038 | $2,082 | $2,136 |
| 0% | 10% | 20% | 30% | 40% | 50% | 60% | 70% | 80% | 90% | 100% | |
| Growth Assets | |||||||||||
Here is the same information presented graphically for the visuals in the audience:
As you can see and, as would be normally expected, the higher the exposure to risk assets, the higher the expected portfolio average (10 Yrs Real Annualised Return on the table / white on the dark blue bars on the chart). Correspondingly, the higher the exposure to growth-oriented assets, the higher the 12-month rolling volatility in returns experienced over the same period (see “Worst Fall” and “Best Rise” lines on the table/bars on the chart). For example, the best 12-month return for the FinaMetrica illustrative 60% growth / 40% fixed-income portfolio shown above is 36.7%. The worst 12-month period saw a portfolio decline of 24%.
The question is, how much volatility (particularly negative volatility or “Worst Fall” volatility) is one prepared to experience in search of a higher anticipated return? When would an investor “cry uncle” and cash in their investments because of a negative volatility experience?
The ability to handle risk and volatility can be financial (stable employment, higher income, lower lifestyle expenses), but it can also emotional. Emotional capacity in turn can be affected by financial capacity (the better a household’s financial circumstances the more confident they might be in accepting risk and volatility) but it can also be a “hard-wiring” issue; how people deal with risk, volatility and resiliency in all aspects of their lives. Some people are more susceptible to more intense negative feelings when experiencing higher negative volatility than others.
It is important to have an understanding of risk and volatility and how our ability to deal with them can impact our overall portfolio returns. At 360 Private Wealth Management | Manulife Wealth Inc. we direct a lot of time an energy establishing and monitoring each client household’s risk capacity as part of our wealth management process.
We use a risk capacity analysis tool from FinaMetrica to help clients understand and assess their individual and household risk capacity. A number of you have completed FinaMetrica's online questionnaires already as part of our ongoing wealth management services. For those of you who have not, and who are interested in completing the assessment process, please contact us. We will send out a link to your own personalized online assessment questionnaire. Once completed, we will send you a copy of the report and follow up to discuss the results and how your overall investment plans fit with your risk capacity profile.
In most instances Portfolio Risk in one form or another cannot be totally eliminated. It is a reality of investing where growth and income are goals in the process. This said, risk and volatility can be managed and where appropriate, minimized. Call or email us to arrange a meeting to discuss your household risk capacity and how our Natural Wealth® Process is structured to help manage portfolio risk while working to generate the returns required to meet the needs of your household Vision and financial life plan.
Again, if you want to complete a risk capacity assessment or have a discussion about your portfolio and the current market volatility, contact us at your convenience.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM | Financial Advisor
360 Private Wealth Management | Manulife Wealth Inc.
Unit 1 – 25 Scurfield Boulevard, Winnipeg, MB R3Y 1G4
Main Office 204.925.5868 | Direct 204.925.2073| Fax 204.925.2263 | Toll Free 844.688.3656