360 Private Wealth Management’s Natural Wealth® Process: Portfolio Risk - Part 1
In the Natural Wealth Process we break the element of Risk into three categories; Person Risk, Portfolio Risk and Property Risk. In our last blog, we reviewed the important aspects of Person Risk. This time around, we want to focus on Portfolio Risk.
Given the increased market volatility and stock market declines investors have been experiencing here over the last couple months, the timing could not be much better to have a discussion about Portfolio Risk. The correction in stocks in October and the more subtle but longer-term decline in bonds over the past year have highlighted the importance of portfolio risk and risk management for investors. At the bottom in October, North American stock markets were off nearly 10% from their highs in late summer; the tech sector suffered steeper losses. Non-North American developed markets (Europe, Australia and developed Asia) were off similar amounts. Emerging market (China, India, Latin America and Russia to name a few) declines were worse.
To begin the discussion about Portfolio Risk, we need to define and, make the distinction between, risk and volatility. Risk, when it comes to investing, can be defined as potential for permanent loss of investment capital. Increased risk should be compensated for with a higher expected return on the investment. As an example, generally-speaking, investor start-up companies or small capitalization stocks (smaller companies) are exposed to higher risk of a potential loss of capital than they would if they invested capital into more established “blue-chip” company stocks. Not all start-up companies or smaller capitalization companies survive. The incidence of failures is higher along with the associated loss of capital invested. For that reason, investors expect a higher return on investments into start-up companies and small capitalization stocks. Over time, research has shown this to be a reasonable expectation.
An important note in the subject of risk within the Natural Wealth model is that we include family businesses (also defined as “private businesses”) operated by client households in the household Portfolio Wealth. The fact that most family businesses would be considered small businesses means, in theory, that client households who own and operate family businesses have a higher exposure to Portfolio Risk than someone who has worked many years for a government employer with a defined benefit pension plan.
Volatility when it comes to investing and investments, is defined as the degree to which investment prices fluctuate from the “mean” or average rate of return. For example, an investment in a stock, ETF or investment fund may have a rate of return of say 8% over a period of 10 years. However, a closer look at each year in the 10-year period might show that the actual returns each year of the investment in question fluctuated between 18% growth and a 10% loss in each year over the time period in question. 8% was the average return over time. The difference between the 8% return and return experienced each year from the average (10% higher than average in the best year and 18% below the average in the worst year in the 10-year period in question). Volatility should be compensated for in an investment. Stocks tend to be more volatile over time, than bonds or guaranteed investment certificates (GIC’s). Small cap stocks and emerging market stocks tend to be more volatile than blue-chip stocks or established markets. History tells us investors should expect a higher return on a more volatile investment, on top of any risk considerations in the individual stocks or fixed investments, or industry or geographic sectors, an investor is considering and investing into.
Risk and volatility must be considered in the context of time and, specifically, the time horizon of the household and their needs from the investment. Risk and volatility and time are all inextricably linked. The longer the time horizon of the household and investment made, the greater the ability, everything else being equal, of the investor to accept an element of risk and/or volatility. For example, a household with a longer time horizon (i.e. a couple in their early 30’s saving for retirement) can accept a higher degree of risk and volatility in the retirement-related investment than someone nearing retirement or someone already retired and drawing from their portfolio. A household saving for a new home or saving for education within a few years of the need, should avoid excess risk and/or volatility in an investment. The question everyone should ask when contemplating an investment and where to invest the money is “Why are we investing the money and, when will we likely need to draw from the investment?”
A special note is advisable on risk and volatility when it comes to retirement and retirement income planning. There is another risk to consider when considering retirement income needs. This is the risk of running out of money while retired. The number of households with someone who is a member of a defined-benefit pension plan is declining rapidly. Companies, and now governments, are considering the costs and financial risks associated with maintaining defined-benefit pension plans. As a consequence, companies and governments (most notably, government agencies) are capping membership in defined-benefit pension plans and moving employees to defined-contribution plans, which are similar in structure to RRSPs in how assets are invested. The result is a transfer of risk to employees who now must be more engaged in the retirement savings and investment process or risk running out of money in retirement. In order to accumulate sufficient capital from which a relatively predictable retirement income stream can be drawn often requires incorporating investments with risk and volatility associated with their ownership.
One more point on the subject of risk and volatility and retirement . . . many households think that the time horizon when it comes to investing for retirement income is the time between where they are now and the planned retirement date; the date they plan to retire and stop earning any work-related income. The fact is that the investment time horizon for retirement income should be considered in the context of how long a household anticipates living beyond the date they retire. The fact is the average individual or couple can anticipate living 20 to 30 years or even longer in retirement. The length of time people can anticipate living in retirement will likely put pressure on their savings and investments, especially if they are invested too conservatively, unless they have accumulated an exceptionally large amount of capital. This is very often not the case, requiring households to include investments with risk and volatility or risk actually running out of money before they die.
I hope you have found this discussion about Risk and Volatility of benefit. When markets are going up it’s easy to lose sight of the fact that markets can go down for periods of time as well . . . Markets have risen for a long period of time here. A correction was to be expected. In our next blog, we will continue our discussion of Portfolio Risk and provide insights on how portfolios can be constructed to minimize volatility and risk while still generating the returns needed to fund our life vision.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM | Financial Advisor
360 Private Wealth Management | Manulife Securities Incorporated
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