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By JoAnne Sommers
Vision Magazine
March/April 2006 Issue
Risk is a normal part of everyday life. But how much risk are you willing to live with for the sake of growing your investments?
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “Before you can formulate a personal investment strategy, you should consider how much — or how little — risk you’re prepared to take with your money.”
In the investment world, there is a direct correlation between risk and return. Generally speaking, investors seeking a higher return must be willing to tolerate a greater level of risk that they will lose some or all of their money. Stocks are generally considered a somewhat risky investment because, among other things, their values can decline if the market declines (market risk) or the issuing company does poorly (company risk).
But all investments carry some risk: even a federally insured bank account is subject to the possibility that inflation will rise faster than your earnings, leaving you with less real purchasing power than when you started.
Investments with predictable rates of return, such as bonds, can have their prices affected by market conditions like a recession, interest rates, inflation or global events. Investing in very safe, short-term investments like Treasury bills (T-bills) also has its downside — you may miss out on greater returns offered by other investments.
Before you can formulate a personal investment strategy, you should consider how much — or how little — risk you’re prepared to take with your money, says Adrian Mastracci, investment counsel and president of Vancouver's “fee-only” KCM Wealth Management Inc.
According to Mastracci, your risk tolerance will be affected by the following factors:
Time Horizon: how much time do you have to achieve your financial goals and make up for any losses you might experience? People with lengthy time horizons may be more willing to endure periodic fluctuations in the value of their investments.
Cash Needs: to what extent do you rely on your investments to help meet your daily expenses? If you need income from your investments to meet your living costs, you probably won’t be comfortable with the prospect of significant losses.
Emotional Factors: what is your emotional response to risk? Every investor is unique: a high-risk mutual fund would keep some people awake at night while others might enjoy the volatility.
There are many tools, such as online quizzes and tests, to help you determine your risk profile (see sidebar). One popular formula involves subtracting your age from 100. The number you’re left with is the percentage of investments you should keep in stocks. In other words, a 30-year-old should put 70% of her money in stock, a 45-year-old 55%, and so on.
Such a rule is very imprecise, of course. As Mastracci notes, “The measurement of risk is relative. Investors can have different personal experiences with the same risk factors.”
He says he uses a lengthy quiz to determine client risk profiles. “The process is valuable because people tend to overestimate their risk tolerance. It’s human nature to think we’re more aggressive than we really are.”
Once clients complete the exercise Mastracci asks them if they’re satisfied with the results. “I want to be sure that they’re comfortable with the profile we’ve developed and the types of investments that are indicated. If the investor has discovered her true risk profile, she’s far less likely to succumb to panic selling if the investments don’t do well in the short term.”
While there are many investment choices, Mastracci says he recommends three strategies for containing risks:
1. Losses
Making portfolio selections is not about always being right. Part of investing is about coming to grips with the prospects of being wrong.
“What hurts portfolios the most is not incurring losses. Rather, it is keeping them far too long. The solutions can be simple, such as adopting a personal selling strategy if the price drops 25% below the purchase price.”
2. Diversification
Diversification involves spreading the investment bets across different investment selections. Portfolios ought to contain a variety of asset classes that do not all move in the same direction.
“Look upon diversification as a welcome and prudent safeguard. Investors do not want problems arising in any one investment to ruin their well-crafted portfolios.”
A diversified portfolio reduces investment risk. If one investment is suffering, the others should help cushion the rest of the portfolio.
3. Rebalancing
Rebalancing involves periodic tweaks to bring the portfolio back into line.
“When you set up an investment portfolio, you should specify your appropriate asset mix. The allocations and weights of the portfolio selections will drift over time due to market forces. That drift can become significant, perhaps also affecting the investment profile.”
“Consider lightening up on the outperformers the next time the portfolio is rebalanced. The other key is buying more of the underperformers. Oddly enough, many investors choose the exact opposite.”
Mastracci says there’s one ultimate test to determine the client’s comfort with portfolio risks. “Does the investor lie awake at night wondering about their investments?” he asks. “Such anxiety is surely not worth the potential rewards.”
In our next article, we’ll look at how to determine asset allocation in your portfolio.
Basic Risk Tolerance Assessment
This test will help you determine your basic risk tolerance profile. But keep in mind that it is subjective. All such tests are imprecise tools so it’s best to discuss your plans with a qualified investment counselor, particularly if you’re an inexperienced investor.
1. What is your age?
1. Under 30
2. 30-44
3. 45-59
4. 60 and over
2. What is your annual income?
1. Over $100,000
2. $75,000-$99,000
3. $50,000-$74,999
4. Under $50,000
3. You have set aside savings to cover a large expense or a financial emergency.
1. Strongly agree
2. Agree
3. Disagree
4. Strongly disagree
4. You are ready for sharp market ups and downs in the short term in return for long-term gains.
1. Strongly agree
2. Agree
3. Disagree
4. Strongly disagree
5. How long do you wish to invest for?
1. 15+ years
2. 10-15 years
3. 5-10 years
4. 1-5 years
6. How familiar are you with investing and different types of investments?
1. I am market savvy and often explain the market to my friends
2. I have a working knowledge of a wide range of investment products
3. I own some mutual funds but I’m not sure if I could explain how they work
4. I usually invest in guaranteed investments like GICs
How to score this test:
If you scored 0-9 points you have a growth-oriented profile. The growth asset allocation model is generally designed for people who are interested in building long-term wealth. Adrian Mastracci says it would probably consist of about 60-65% Canadian, U.S. and/or global equities and 35-40% fixed income assets, such as T-bills, bonds, GICs and strip coupons.
If you got 10-16 points, it indicates a balanced profile. This is a compromise model, located half way between the growth and income asset allocation models. Portfolios based on this model try to strike a compromise between long-term growth and current income. Balanced portfolios tend to divide assets evenly between equities and fixed income assets. Real estate holdings are often a component as well.
If you got 17-24 points, it indicates an income-oriented profile. Portfolios that are designed to generate income for their owners often consist of about 35% equities and 65% fixed income assets, according to Mastracci. The typical income-oriented investor is one who is nearing retirement.
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