Today we are going to talk about risk.
As a consumer, saving money is tied to a goal—you’re saving for something. You plan to save a certain amount of money, say $500,000, for retirement at some point in the future. In order to hit that target, you can put your money in a variety of places: cash, bonds, stocks, mutual funds, cryptocurrency, etc. In order for you to appropriately plan for the future, you need to know two things:
when you will need the money and
how much you will need.
Using this information, we can figure out how much you need to save, and what kind of returns you need to hit your goals.
So what does that have to do with risk?
The One Big Risk
As we talked about previously, the number one risk you face as a consumer is not having enough money to hit your goal. This could be not enough money to retire, to go on vacation, or pay for your new house. We’re going to look at how companies set you up for failure.
If you have ever contributed money to mutual funds or opened an account at an online brokerage or Roboadvisor like Wealthsimple, you likely took an Investor Profile survey. The company attempts to assess your appetite for risk to assign you an appropriate portfolio. But I want to make something very clear: this is mostly pointless.
How much risk you feel comfortable taking on has no impact on how the market will perform or how inflation will devalue your money. The market will return what it returns, whether you participate or not. The risk that these companies portray is how you would feel losing a specific amount of money, or what would happen if the market experienced a downturn. These types of questions lose the context of why you are saving and the associated timeframe.
By recommending a specific portfolio based on how you feel is dangerous and harmful to you as an individual investor. In theory, there is a correct portfolio for you based on your specific situation. There is a specific target rate of return that you need to achieve, and a portfolio can be constructed accordingly. This is a naive assessment of returns, but I will argue there are definitely wrong portfolios, as there is no way they will help you hit your goal.
A simple example: You need to save $5,000 in 5 years, and are able to save $1,000 per year. Additionally, you will need to achieve a return that keeps pace with inflation, meaning you should take on low-volatility (stable) assets. If you are a "risk-seeking” individual, it still wouldn’t make sense to suggest you put that money into equities or cryptocurrency, as they aren’t helping you hit your goal.
What about something more complex, needing growth? You want to have $10,000 in 6 years and you can save $100/month.
Using this information, we can easily determine the amount of return you need. A quick, rough calculation states you would need a 17% return annually, assuming 2% inflation. This information is much more valuable, as you are now in a position to assess investment options.
Your target rate of return is 17%, so you need to identify opportunities that can help you hit that. Your risk tolerance becomes less of an issue, you should assess investment options through "potential return bands”. For example, most portfolios state returns as:
90% chance of 5-8% return.
10% chance for >10% return, etc.
You should take on investments that have the highest chance of hitting that goal. A “safe” portfolio that makes you feel better as a low-risk individual gives you a 100% chance of you not hitting your goal. Is that really low risk?
What about your feelings?
Let’s hold up for a minute.
I previously mentioned that how you feel about the market has no objective impact on returns. We already know is that people don’t manage volatility well. The biggest impact on your financial performance in the long-run is your behaviour in the face of uncertainty, not your portfolio. We have a bad habit of making poor emotional investment decisions. The solution for this is adding friction between you and your money – a financial advisor, a trusted party, or an online platform plus discipline. Take your pick.
If you have no stomach for uncertainty and your savings goals require a high return, such as the above example, you are stuck in a tough or impossible position. You aren't going to hit 17% returns with certainty. You will need to either flex on your goals or your behaviour. Luckily, each of the inputs in the formula—monthly savings rate, target savings, and the end date—can be changed to lower the required rate of return. This won’t solve behavioural challenges but might make it easier for you to stomach volatility.
Shortcomings
The problem with most financial planning tools is that they forecast according to current behaviour (savings rate) over a set period of time along with our expected return to figure out the end goal. This is a bit silly. It’s like saying “I can drive 500 miles a day and I plan to drive for 10 days”, and the map tells you where you will end up in 10 days, instead of saying “I am in Seattle. I want to drive to Miami in 10 days. How far do I need to drive each day?” The former lacks the context of your goal.
Most financial writing uses the past performance of stocks to say “index funds are safest, you won’t beat the market, just put 10% of your income into index funds and you’ll be set”. This is naive and misleading, as this again, lacks your personal context. Who is to say that the average market return is enough to satisfy your savings goals? What if only way to hit your aggressive targets is through alternative private investments or more strategic stock picking, getting returns of 15%?
Ok let’s get to the one practical tip portion.
The two implications of this are:
If you are risk-averse and have selected a portfolio based on this using a platform like WealthSimple or your own mutual fund provider, know that you are taking on additional risk, potentially guaranteeing you are not meeting your savings goals.
If you don’t trust yourself to make sound financial decisions when things get rough, use a financial advisor. Automation is only great if you have the discipline to leave it untouched.