SideOne Magazine Volume 1, Issue 3 - November 2020

SENSIBLE DOLLARS

Are you protecting yourself against the wrong risks?

By Allan Kunigis

Allan Kunigis is a Canadian-born freelance financial writer based in Shelburne, Vermont. He has written about personal finance for more than two decades. He is the author of A Kid’s Activity Book on Money and Finance: Teach Children About Saving, Borrowing, and Planning for the Future, published in September.

I was sitting at a table with eight other people – friends and family members – at a Covid-safe dinner party recently. We were in close proximity but on a screened porch, rather than indoors, where germs might be more likely to spread. How much protection that screened porch actually offered us is debatable.

After dinner, someone lit a joint and passed it around. Some of us puffed, some passed. My daughter, sitting across from me, observed how ironic it was that we were sitting outside, bundled up as the temperature dipped below 10 Celsius, to protect us against COVID risk while a joint was travelling from lips to lips.

Remembering that odd scene reminded me of our attitudes toward investment risks and our exposure to them. Sometimes we think we’re safe because

we’re focused on one type of risk while maintainingfull exposure to an even more dangerous set ofperils.

Here are some common mistakes we make inmanaging investment risks:

1. MISTAKING SHORT-TERM VOLATILITY FOR RISK

Market volatility is a key concern only in the shortterm. What happens tomorrow, next week, ornext month probably will mean very little 30 or40 years from now. The longer your time horizon,the less relevance today’s market ups and downshave. All other things being equal, more volatilityin the short run could be a sign that you areappropriately invested for a long-term goal.

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That’s because risk and reward generally gohand in hand. As an investor, you tend to becompensated for taking on a greater degree ofrisk in the short term. That’s why stocks, whilemore volatile in the near term, can be less riskyoverall for many retirement investors decadesaway from their target date, while low-yielding socalled“safe” investments could make it harder toaccumulate a large-enough nest egg.

The essence of managing overall investment risk is diversification. It’s fairly easy to grasp the benefit of not having all your eggs in one basket.

2. IGNORING CONCENTRATION RISK

The essence of managing overall investmentrisk is diversification. It’s fairly easy to grasp thebenefit of not having all your eggs in one basket.Investing in mutual funds can quickly providediversification. That can, at least, spread yourrisk across dozens or hundreds of companies. Butjust having a collection of funds in your portfoliodoesn’t guarantee that your investments aresuitably diversified.

First, look at the dominant stocks in Canadaand the United States that will make up a largeproportion of a broad index fund tracking theCanadian stock market’s proxy, the S&P/TSXComposite Index, or the S&P 500 Index in the U.S.

In Canada, large banks dominate the marketand are well represented in a typical index fund.Investing in a non-index or actively managedCanadian stock fund that focuses on largecompanies can result in similar exposure to thisone sector and these mega-banks. Your financialfuture will be closely tied to their fortunes. Would

you consciously and deliberately seek that out?Large oil and gas firms also dominate the Canadianstock market. If you own shares in a Canadianindex mutual fund, you probably have extensiveexposure to the energy sector. If that’s a consciousor deliberate decision, fine. Otherwise, be awareof your risk exposure and consider what you wantto invest in and why.

In the U.S., the so-called FAANG stocks – Facebook,Apple, Amazon, Netflix, and Google (owned byAlphabet Inc.) – dominate the equity indices and,most likely, your portfolio. Vanguard Investments’S&P 500 Index Fund, with more than $330 billionin assets, holds large chunks of stock in Apple,Microsoft, Amazon, Facebook, and Alphabet. Inall, roughly one-quarter of all assets in an S&P500 index fund are in these five mega-sized techstocks. That’s not diversification. That won’tprotect you from a major economic event thatcould affect all these companies.

To avoid this kind of concentration risk, seek outexposure to vastly different types of investments.You could own an emerging market stock fund,an emerging market bond fund, a high-yield bondfund, a government bond fund, a large, diversifiedglobal equity fund, and equity funds that focus onsmall and mid-sized companies rather than justthe dominant household names.

3. FORGETTING ABOUT LIQUIDITY RISK

Liquidity describes how easily you can turn aninvestment into cash. If you invest – directlyor through a mutual fund – in stocks that tradefrequently, like the above-mentioned commonstocks, you’ll be able to cash in those investmentsquickly when you want to sell them. That’s good.Where you would run into liquidity problems is ifyou had a lot of money tied up in private equity orreal estate. How quickly can anyone sell a house,apartment building, or office complex?

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Where you would run into liquidity problems is if you had a lot of money tied up in private equity or real estate. How quickly can anyone sell a house, apartment building, or office complex?

Another important aspect of liquidity risk is: What happens in the event of another global financial crisis? In 2008, investors who were desperate for cash engaged in panic selling, anxiously selling anything, including very solid stocks that quickly lost tremendous value. If you were unable or unwilling to ride out that rocky period, you lost money. The best way to protect yourself from that risk is to keep enough of your investments in cash or a cash-equivalent account. How much is enough? Perhaps enough to cover six months of your living expenses, the classic emergency fund.

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If you’re investing for your retirement or any goal decades away, don’t ignore how much inflation can diminish your purchasing power. When planning, factor that in.

4. NEGLECTING INFLATION RISK

If you’re investing for your retirement or any goaldecades away, don’t ignore how much inflationcan diminish your purchasing power. Whenplanning, factor that in. It’s even more importantto invest in a mix of assets, including stocks,for long-term investment goals. That’s because,historically, stocks have outperformed otherassets over the long term and have generatedreturns that exceed the inflation rate. Althoughthere are no guarantees, these are well-establishedbroad patterns.

5. OVERLOOKING LONGEVITY RISK

Longevity risk is the danger of running out ofmoney before you die. Similarly to inflation risk,to manage longevity risk, keep at least some ofyour investments in stocks and other assets, likereal estate, that have the potential to generatelarger long-term returns. Maintaining broaddiversification, including having some of yourinvestments in stocks or stock funds – see #2above – should help protect against longevity risk.

HOW TO ASSESS YOUR RISKS AND PROTECT YOURSELF

First, determine your investment goal and timehorizon. If you have several investment goals, set upseparate accounts for each one.

For a short-term goal, like a special vacation or

sabbatical, or helping your child gather a downpayment for a home in the next few years, you’llprobably want to protect your principal. The priorityis to keep your money safe. Consider a bank accountor guaranteed investment certificate (GIC). Yourbiggest concerns are volatility risk and liquidity.

For a medium-term goal, perhaps five to 10 yearsaway, you might take a more balanced approach.Volatility still matters, but to a lesser extent. You canseek a higher return than you’d earn in a GIC or bankaccount. Most investors would be comfortable witha mix of stocks and bonds, or with a balanced mutualfund that owns both stocks and bonds, typically ina range from 50 per cent stocks/50 per cent bondsto 65 per cent stocks/35 per cent bonds. Based onthe mix of assets, your overall return would fallsomewhere between what you’d earn in an all-stockor all-bond portfolio.

For a short-term goal, like a special vacation or sabbatical, or helping your child gather a down payment for a home in the next few years, you’ll probably want to protect your principal.

For goals of 10 years or longer, you can afford tolean more heavily on stocks, as they have tendedto perform better than bonds or cash over longerperiods. And the longer you have before you needthe money, the less relevant today’s market ups anddowns will be for you.

In summary, know why you are investing and for howlong. Then think clearly about the key risks you’llface in achieving your goals, and manage againstthem. Otherwise, you might as well be passingaround a joint among friends during a pandemic!

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