“Risk-Averse Financial Planning: The Meek Shall Inherit Stability” is a post by Adina J, TimelessFinance columnist and author of Blue collar / Red lipstick. |
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Today, I am going to attempt to tackle a difficult topic that strikes close to home for me: how to incorporate risk into your long-term financial planning when you are risk-averse. It’s difficult because, well, I know I’m risking having all you investment whiz kids out there roll your eyes at me. Oh, the irony! Maybe I like a little risk, after all.
Still, by nature, I am the opposite of a risk-taker. I know – and hate – that there are no guarantees in life, but I want the next best thing. I want an almost sure thing, hold the “almost”. As you might imagine, my inherent aversion to risk has seriously hampered my financial strategy in the past. Risk is a crucial element of long-term financial planning, whether it’s at the active-income stage or the passive-income stage (which might be one and the same for some people). My risk-averse nature is one reason (among many) why I will never be a full-time entrepreneur. Because that isn’t something I am interested in changing, I realized it was all the more imperative that I become able and willing to countenance some degree of risk on the other side of the equation: investment.
I’ve had money in and out, and in and then, finally, out again of mutual funds since the age of 21. When I first started, I picked mutual funds as my investment vehicle of choice because, well, I didn’t know any better. Literally. My parents were fantastic about teaching me how to save, but not so much about how to invest – mostly because their lessons were taught by example, not by discussion; I knew my parents had money in the bank, I just never knew what they did with it. However, I had heard generic references to mutual funds in the media, so I figured that mutual funds were the answer.
A decade later, I figured out my mistake. My point here, though, is that I’ve been invested “in the market”, so to speak, for a comparatively long time for someone in her early 30s. (If you were not already convinced of the futility of mutual funds, let me pause here to add that, over that time, I barely broke even. Obviously, my mutual funds fell into that 50% that never ended up beating the market, despite the much-vaunted prescience of their managing analysts.) Yet, until very recently, I was never able to muster much courage to really “take on the market”. My mutual fund picks were always firmly on the conservative side of the spectrum, which meant that I rarely saw the upside of booms, and which translated into negligible returns. I never won big, and I never lost big; basically, between inflation and MERs, my investment died a slow, protracted death by a thousand paper cuts. (Credit for this phrase goes to Garth Turner who certainly has an ear for the pithy sound-bite and who, as Joe says, deserves the Order of Canada.)
And that, in essence, is the fate of the risk-averse in the financial sphere. You’re just sort of … there. Whatever market conditions favour the risk-averse – and I am not sure there are any – they did not materialize at any point in the last decade. With my twenties firmly behind me, I am no longer willing to take the risk – ha! – of waiting for them to possibly materialize at some point in the next 30 years. That said, it can certainly be an uphill battle for the rational mind to overcome one’s instinctive prejudices. When your gut instinct is screaming “Stash that money in a mattress!!”, how do you go about convincing yourself that the right thing to do is giving your money to a diagnosed bipolar, Mr. Market?
I wish I could tell you that I had an epiphany one day, after which I single-handedly developed a diverse portfolio of acronym-ed investments that has me beating the market with one hand behind my back. That didn’t happen. What did happen is that I finally staunched the paper cuts, and switched my family’s medium- and long-term savings into index funds. The other thing that happened was that I diversified across four different index funds – each with different exposures and levels of risk. My strategy, and motivating ideology if you will, was inspired by a book I’ve previously mentioned in passing, The Black Swan
What ultimately really resonated with me was Taleb’s approach to investing. He writes that his preferred means of dealing with uncertainty and possible black swans is to determine a threshold for his risk tolerance; in other words, how much he is willing to lose in a worst case scenario. He takes that amount and invests it in the riskiest ways possible, keeping everything else in relatively safer investments (but not in his mattress, presumably). As simple as it sounds, this approach was an eye-opener for me; it got me to think about ways that, short of picking individual stocks, I could tailor a personalized portfolio of investments without professional expert help. I had always thought about mutual (or index) funds as an all-in proposition, but I finally started to ask myself why that had to be the case. The idea of allocating varying amounts to funds with differing risk quotients – according to my formula, not the bank’s – was very appealing. The bank’s categories of investors, which are used to identify the “best” funds for each individual according to their supposed “type”, are about as accurate in addressing individual circumstances, needs and idiosyncracies of personality as I am in hitting the bullseye at darts, in the dark, after a tequila bender (Editor Joe’s Note: I, too, end up in this exact situation all the time). And, moreover, so what if, based on the bank’s dozen ever-so-insightful questions, I am considered a conservative investor? The point (which no bank rep has ever taken the time to explain, I might add) is that I SHOULDN’T be one at this point in my life … not if I don’t want to spend my retirement bumming change off my kid.
Bank-directed diatribe aside (don’t they always feel so satisfying?), the point is that reading a book about the unpredictability of life- (and market-) changing events, paradoxically, helped me to break free from my risk-averse, drone mentality. Strangely enough, once I embraced the concept of a high-risk component in my portfolio (10% in my case), I actually found myself more willing to up the risk quotient in the remainder of my investments, whilst feeling more comfortable than before with my overall exposure; perhaps, it felt all ”safer” by comparison – psychology is a funny thing. The breakdown of my portfolio now looks something like this: 10% higher risk index funds, 40% medium-risk (spread across two index funds focused on different markets), and 50% relatively “safe” investments (Canadian bond index fund-type stuff). I am curious to see how this strategy will pan out over the next while, as compared to my husband’s more traditional, bank-approved approach (as it turns out, I am actually not the most risk-averse person I know).
Considering the general financial acumen of TF’s readership, I expect that many of you will have plenty of constructive (or just plain) criticism for me, which may come in handy next time I need to tweak my portfolio. But I am especially curious to hear from other fellow risk-avoiders: how do you accept risk, and in what measure, as part of your investment strategy?
I hate risk too…my first retirement accounts were in certificates and those will forever renew as certificates, part of my fixed income allocation.
I finally started investing in the stock market after college. I like index funds – they feel a lot less risky to me. I’m so glad my 401(k) was at Vanguard or I might have opened an IRA/taxable account at some expensive place :/ One of my friends suggested using the (110 – age) rule for my stocks allocation, but I eventually realized that was too risky for me, so I switched to (100 – age) and that is feeling better. What helps me feel okay about investing in stocks is that I have so much “discretionary” income (so far this year, I’ve saved about $50k) that I really am not putting money that I need anytime soon into stocks.
Another way that I’m being risk adverse is paying down my mortgage instead of using it as leverage to invest cheaply. And my asset allocation strategy calls for an increase in the fixed income allocation for every $100k in investments. So next year, my target asset allocation could increase two percentage points for fixed income, depending on how much I put into my portfolio and how it does.
I’d be comfortable with not paying down a mortgage on a cashflow-positive rental property — the leverage increases the return, after all. But a home is not an investment. I think you’re wise to pay it down. Can the intelligent use of leverage make you richer, faster? Absolutely. But when you’re making over 6 figures, being frugal, and investing intelligently, you’re on a track to being rich anyway.
Adina, thanks for this post.
“Higher risk index funds” = what exactly? Index funds are by nature index tracking and diversified in their sector and less risky, curious as to what index fund you have purchased that you consider high risk? Precious metals? Energy? some sort of REIT exchange traded fund?
I assume these are ETFs, not index mutual funds? Are you using a discount brokerage? Sorry if that was answered in your post.
When you say “relatively ‘safe’ investments” and put “bond index funds” in the same sentence, I’m a bit concerned. Even people as conservative and wacky as Suze Orman are eschewing bond funds right now, because rates aren’t going much lower. They may stay flat until 2013 or 2014, hell they could drop 0.25% and you’d recognize a small gain, BUT the time to invest in bond index funds was 3-4 years ago. Buying them now does 2 things. 1) your returns are a pittance because interest rates are low and the price of the safe bond funds so high that the yields are negative after inflation 2) nearly guarantees a capital loss when rates inevitably rise from their record lows in the next two years.
Money where my mouth is, I sold out of my bond funds after QE3 was announced last week (haven’t bought any in years) and put the big gains into preferred paying ETFs and solid dividend paying stocks what I used to have there. You get the income of the dividends with room for appreciation (unlike bond funds). Preferred ETFs = the new bond index funds.
Just my thoughts on those, but you’ll find a lot of people warning away from bond index funds. Bond funds that don’t track an index can sell out of longer term bonds when the rate change noise gets high, and short term bond funds mitigate the risks on capital, but a regular 5 year or 10 year bond index fund would not be where I’d stick 50% of my retirement money given the interest rate environment we’re in, which is unprecedented in history and certainly not taken into account by all those wacky 90s and early 2000s PF books. Again, just my thoughts.
For risk, I use my TFSA for risky investments. It’s a relatively small amount of money at this point for everyone (max at $20,000 a person) and if you hit the lottery and make a big gain you can cash out with no tax or waiting period. So I own a few individual stocks in this one as well as some of those TD eFunds (my S&P500 efund is doing well). I use Waterhouse.
On the less risky side, I use my work DC plan. Here I get (for now) 11% of my gross pay contributed by the company, and then an additional match of half of whatever % I contribute up to 4%. So I contribute the maximum I can 8%, they kick in 4% + 11% and I end up having 23% of my gross salary going into Sun Life’s woeful group of mutual funds. Soon I’ll run out of the excess RRSP room and have to lower that down but for now it works since I wasn’t a saver in my 20s.
At Sunlife, basically try to find the funds that have the lowest MERs and the best record of tracking an index and them aim to diversify between US, Canada, International and Income with a heavy weighting on equities. I’m lobbying hard to get access to Blackrock Index Funds for my company through Sunlife.
I will caution everyone, those Lifeplan/Granite/Date funds like 2040 Target Date Fund seem to be doing very poorly and returns very low relative to others, if you have one of these at work do some due diligence work before you stick all your retirement into one!
Sorry for the rambling, I haven’t had coffee yet and am too busy to edit or revise.
Sorry, Adam! I am still about 10 steps back from where it sounds like you are. I am only talking about index funds, not ETFs. I’m not ready yet to completely break away from the bank, so this was my first step. I do take your point about the bond market, though, and it’s probably something I will have to re-assess shortly.
Basically, I feel a bit like I’m in limbo right now. On one hand, I have progressed beyond the level of basic investment (aka savings accounts and mutual funds) that most Canadians are at, TF readers aside. On the other hand I don’t have the time now (not a whine, but just the honest truth, between a 50hr work week, a toddler and two blogs) to spend on finding a good brokerage, researching stocks, and truly actively managing a portfolio, which seems to be the next level, but a really big step from where I’m currently at. I hate compromises (which is what my current strategy still feels like), but I’m still trying to find a way to navigate from point A and point B.
“…researching stocks, and truly actively managing a portfolio, which seems to be the next level…”
Actually I would strongly disagree. Unless your last name is really Buffett, and you are really a man named Warren, then “actively managing a portfolio” is about the last thing you want to attempt to do. This is not in any way a knock on you personally, but the sad truth (that the banks and industry would like to hide from you) is that even professional “active managers” routinely fail to outperform the market with any degree of consistency. The odds of you (or I) consistently outperforming the market through research and active management is approximately zero.
Therefore your strategy can only be to seek to mirror/capture as much of the market return as possible, while minimizing risk and volatility. A simple portfolio of a few low cost ETFs or index funds can help you do this, consistently, and beyond “initial setup” (and the learning that goes along with it) require almost no time on an on-going basis.
To try to do anything more, all the data tells us, will almost certainly result in actually lowering your returns, while consuming your time and increasing your stress level. Here are some sample portfolios that can be effectively implemented in a low time- and cost-overhead manner. http://canadiancouchpotato.com/model-portfolios/
I’ve read the comments down through VI’s, and I just want to say that the level/quality of discourse on this post is absolutely stunning. And, as always, great post Adina. Your honesty/candor makes your articles fun to read and your writing makes them easy to edit (i.e. my editing of your articles is to editing what couch potato investing is to active investing).
As far as investing vehicles go, I’d choose a combination of these three:
- TD eSeries funds (index mutual funds)
- Index ETFs (traded through Questrade); and
- Dividend stocks (traded through Questrade)
Based on this/previous articles, it seems like you’re on #1. I’m sure you could do OK with TD eSeries in the long run.
I think #3 is the ‘active investing’ you’re referring to (unless you’re talking about just throwing your money at certain stocks, in which case, please don’t). It’s the kind of trading that Danno and VI don’t like. And with good reason — read VI’s guest post. But the truth is, I’ve made much higher (tax-advantaged) returns on the portion of my portfolio that I’ve done ‘dividend investing’ with than I could have hoped to achieve with index funds.
#2 is probably the sweet-spot to hit and you should aspire to it. Yes, it costs $5 – 10 to trade an ETF (use Questrade and use my banner in the right column to get $50 in free trades; sorry needed to throw in that plug). But you can get TSX-traded Vanguard ETFs where the MERs beat the $#!T out of even TD eSeries funds. So you can reduce your costs (and therefore improve your returns while holding risk equal) simply by improving your investment vehicle as a couch potato.
[Side note: let's say you had a windfall (I was just chatting with my affiliate rep at Questrade today about this idea) you can employ some interesting strategies with ETFs to deploy money without dollar cost averaging (while still maintaining a lower risk profile), e.g. buying a covered call ETF that buys banks and pays dividends like ZWB (it's not an index, the MER is 0.65% but it protects against downside). Anyway, ETFs are just incredible because you can do so much with them.]
Now as for specific instruments to hold…
I am cash-heavy. I’m waiting for the Canadian housing market to implode. Ignore what I’m doing cause you’re already long on housing (bon chance!) and you’re looking to prudently acquire liquid, cash-bearing investments.
Bonds suck. They suck less in registered accounts cause you don’t need to pay tax on interest income now (RRSP) or ever (TFSA). But as has been astutely pointed out, the yield curve took Viagra. Interest rates and bond prices are inversely correlated. When these rates go up (maybe not soon. Who knows? housing is collapsing already without an increase. but they WILL increase) then bonds are “pooched” as you and the Bearded One say.
The only bonds I’d touch with a ten foot poll would be in a junk bond ETF. That’s cause the yields are already crazy high; you want the income not the capital gains (Morpheus: “What if I told you that the bond market is 100x bigger than the stock market and that bond prices fluctuate above and below their face values?”). High risk, yes, but you’re diversified across a lot of junk bonds.
REITs are great, although it’s the worst time ever to buy a Canadian REIT (apologies to Garth Turner since he seems to think commerical real estate is a BRILLIANT investment; this completely ignores the US and Australian experiences where real estate popped and resulted in a collapse of commercial real estate). Put money into an American REIT (caveat emptor re: tax law), but not Canadian.
Equities are where it’s at.
RRSP — US index funds, international index funds (are int’l exempt or is it only US? If only US then disregard int’l, might as well put them in taxable)
TFSA — junk bonds and “high” interest savings
Taxable Accounts — Canadian eligible dividend-bearing stocks and index funds
Or something like that. I would love to see anybody else’s thoughts on the most tax-efficient and investment-wise allocation for RRSPs, TFSAs, and taxable accounts.
I have a defined benefit pension and, given the recent cover letter I got with my annual statement (‘we may reduce benefits going forward’) and the government’s beating of the war drum about the evils of me getting a paycheque to feed my family, I’m thinking it counts as my “risky investment” portion of my portfolio.
http://canadiancouchpotato.com/2012/09/20/foreign-withholding-tax-which-fund-goes-where/
The post that Leigh pointed to is a great one (not sure what she’s doing reading about Canadian tax law
). Depending on the situation, you can have taxes even in an RRSP/TFSA. Understanding that overview is important to getting the most out of your portfolio (and I’m almost there).
Keep in mind that even a broad large cap index fund can have years with really good returns. 7%+ for Canadian bonds last year isn’t too high but it’s still unexpected upside, and equities can do 20-30%+ in a good year. As with everything else, you might want to reconsider how much you hold after that year. Stocks actually have very high or low return years more frequently than they have average returns. A low-volatility option strategy can narrow the range of returns if you want, but that has costs that typically lower your long-term returns. If you’re invested for long enough to not care about the volatility, that’s a needless cost.
Covered call funds fall under the same category of lower volatility and lower returns. Of course they can mask it by playing around with cashflows. An article I came across a few months ago highlighted investors in the US who believe their high-yield funds with 10%+ income are sustainable, when in fact they are just returning capital every year (in some cases they have less than 5 years go to). That will be a big surprise one day.
I’m not sure what would make a good risky investment with a chance for big gains. Distressed junk bonds might do it since they could shoot up if the issuer recovers. Options might be good if you find a possible big move (maybe Joe can find some options that are influenced by Canadian real estate prices or Ontario’s fiscal difficulties!). If you can find something where you have a reasonable chance of being right, no one believes it right now, and it doesn’t cost much to make a lot of bad bets, you might be on to something. There may be more opportunities with shorting but you can lose big there.
The problem is that every risky investment has an opposite that’s also available. For example you could narrow things down to two risky choices currently available, the ETFs that give you twice the S&P 500′s daily return and twice the inverse respectively. Two investors could each choose one of those as their risky investment and seemingly just transfer cash back and forth. But it’s really worse than that. The riskier and more complex things get, the more you are exposed to weird volatility. Both of those ETFs actually lose money over the long term in a moderately volatile market (ie a market that exists in the real world), regardless of which direction the market is going. If they were opposites that would make things hard enough, but they are really both losing investments unless you hold the right one for a short time when the market is making the right moves. The biggest returns go to the institutions collecting fees.
If you want to get into active management and you can successfully work with choices like that, you might be able to find a big return. If you choose more conservative active management you’re only talking about marginally higher returns in the best case, so you want to make sure the cost of getting those is worth it.
That actually gives me an idea… if I wanted to play around with options I might look at making a spread trade with options that would benefit from RIM stock rising and Apple stock falling. I think that means selling call options on Apple and buying put options on RIM (probably out of the money in both cases). You could do this with little starting capital since the proceeds from selling one option would allow you to buy the other, but then you have the risk of paying the cost of a call option that’s in the money later. In my uninformed view, both stock prices have been pushed pretty far in the opposite direction and might have a good chance of getting closer one way or the other. The options must be pretty cheap at the moment too.
Excellent post. Seems like you have the right approach from the high level, although as Adam P points out, the devil is often in the details. Not sure if you know of this site, but it is completely fantastic, and you may find it useful, as you are most certainly a Couch Potato.
http://canadiancouchpotato.com/
As for the “safety” of bonds, I very much share Adam P’s concern. For the last 100yrs or so, bonds have indeed been a reliable “safety” investment. But as the very crux of this article points out – things stay the same until one day they do not. For all I know, half the countries/corps around the world could end up in default tomorrow, rendering my “safe” bonds actually rather useless. The point of your article, though, and of the Couch Potato religion, is that you cannot possibly know if or when that will happen, so all you can do is diversify, and try to “capture” as much of the market index return as possible (versus losing it to fees and poor/inefficient investments). To attempt otherwise, fundamentally, unless you are clarvoyant, is just guessing.
For me, I am in my 30s, and I use a 30%/70% bond/equity allocation in my RRSPs, but prefer to keep my TFSAs a bit safer, and use a 50/50 allocation there. I use only low cost ETFs and index funds held through discount brokerages. And I rebalance using a set of “rules” that I laid out for myself. One thing that is extremely important to me is to take the EMOTION out of investing. The value of my investments invariably moves up and down. It’s very easy to look at that and become emotional. And your emotions will usually tell you to do (at least historically) the wrong thing – get into something when it’s doing well and out when it’s doing badly. Generally, you want to do the opposite. If my equity holdings start dropping, I want to begin moving money into them, not out, and visa versa. Having a set of “rules” about when you rebalance makes the whole thing mechanical rather than emotional. Stick to the rules of the machine and your emotions will not hurt you.
Also, on the subject of overall risk level, I absolutely love this page. I personally think that most people THINK they need to take more risk than they actually do in order to achieve their goals. Most, I think, would be surprised at how well (again, at least historically) portfolios with much lower risk allocations have performed over time. I suppose we’ll see how well that holds between now and the time I am 65.
https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations
It’s funny, when you put it that way even my “risky” investments aren’t that risky
While the strategy of safe + risky sounds good, there are so many investment options that a lot of them aren’t even risky (in the sense that you could make a lot or lose it all), they’re just plain bad (in the sense that you will probably lose it all). I have a feeling that it would take a lot of research and sector-specific knowledge to even identify what looks like a good risk. Taleb apparently did it by trading options for long enough to know when certain options had a small chance of big returns, and saw enough of those that eventually one of them was likely to pay off. If you don’t have good risks, then you just end up with your safe component plus a guaranteed loss.
I don’t actively seek out things like that, but last year I did get some shares in a Mortgage Investment Corporation because it pays better interest rates than just about anything else, it should go up when rates increase (shares don’t trade openly so there isn’t a corresponding price loss), and they actually have a believable story about protection of capital. This is risky because it’s still small enough and narrow enough to sustain big losses in all kinds of ways (up to and including fraud), but if it works out it will increase returns by a bit. It’s currently 2% of the portfolio so it won’t be a lot