By Mike Fortunato, CIM®, FCSI®

image:https://econompicdata.blogspot.com/2010/08/housing-greed-fear-bottom-cycle.html

 

In the previous two instalments of this article I described how the rollercoaster ride investors experienced (as the market peaked in 2007 and subsequently nosedived in 2008) was foreshadowed by posters displayed in several bank branches throughout Ontario, where I worked as a teller at the time. Ironically, the investment products promoted in both posters were ill-timed for many investors to take advantage of their benefits:

• First, equity mutual fund posters arrived in the late summer of 2007. Although the funds had terrific past performance, they were doomed to experience substantial declines as the market eventually collapsed a few months after their posters went on display.
• Then, in the middle of 2008, as the market continued to crumble, GIC posters were displayed, which were too late to protect many investors from losses that occurred earlier in the year. Also, investing in GICs in late 2008 came with a huge opportunity cost by tying up investor’s funds (at extremely low yields) just a few months before the market was destined to being its multi-year rebound.

In this last instalment I’ll describe how investors were thrown one final loop-de-loop in this rollercoaster ride, that again involved yet another untimely poster (as the market was beginning its recovery in 2009).

Before I lift the curtain on the final act of this real-life drama, I want to give you some background about my disposition, at the time this was unfolding. A few years before joining the bank I had begun studying economics and wealth management as a hobby. I was particularly interested in the concepts of investor psychology and the field Behavioural Finance. At the time, I was actually more concerned with trying to become an investor verses trying to find a career in the finance industry. I spent much of my spare time consuming the financial news, reading books about investing, and testing various strategies in the markets. I continued studying while at work too, as I made it a habit to learn from every customer I spoke with. By viewing each customer interaction through the lens of Behavioural Finance I was able to gain huge insights about the micro-economic forces that assemble to form the macro-economic phenomenon commonly referred to as “the mind of the market”. I had certainly been in the right place and the right time in history to be studying investor psychology. First, I witnessed how flashy historical returns, displayed in our equity mutual fund’s poster, played on the emotion of greed and enticed many investors to go ‘all-in’ near the top of the market. Then, as the market reversed, many investors panicked as their losses accumulated and were allured to the promise of “guaranteed principal” advertised in our GIC poster. Falling victim to the emotion of fear, those that sold out near the bottom of the bear-market, to move into GICs, were also guaranteed to exacerbate their losses with an extra-long recovery due to the low yield of these ‘safe’ investments.

As 2008 was ending and 2009 was beginning, I recall reflecting on the last 18 months since becoming a bank teller in the summer of 2007. It was quite a ride. At that time many investors were still too terrified to invest in stocks because the market still hadn’t shown any signs of letting up from its one-year plunge. Looking back now in hindsight, however, it is clear that this was the best time to start investing in equities again, as the markets have been steadily rising for almost 10 years since bottoming in the early spring of 2009. I could understand investor’s fear however, to invest in stocks again, as their portfolios had been devastated the prior year. It was during this emotional time that the final poster in this saga appeared on the display wall at my branch mid-2009. It was advertising one of our bank’s bond mutual funds. Although it didn’t boast returns as strong the equity fund poster from 2007, it did showcase a mix of high-single-digit (5-year) & double-digit (3-year & 1-year) historical returns. This new bond fund poster must have shined like an oasis to many of our investors given that the other mainstream alternatives at the time were: near-zero-percent yielding GICs and a stock market that had fallen approximately 50%. In light of all the turmoil they had recently experienced in the stock market, I wasn’t surprised that about half of our clients viewed this new poster more like a mirage instead of an oasis. But those that weren’t skeptical actually viewed this bond fund as a better alternative than GICs to claw back all the losses they had experienced.

Historically, it is rare for a bond fund of that nature to have returns as high as the past returns showcased in our poster. Leaving aside the skill of the portfolio management team (which I’m sure was great), there were two main reasons why our bond fund had such a strong 1-year, 3-year & 5-year historical return:
Interest rates had just been aggressively lowered by central banks who were trying to inject liquidity into the financial system.
Large institutional investors moved funds into government bonds in hopes of finding a stable place to ride out the storm.
Both of these factors placed tremendous buying pressure on the government bond market, which caused bond values (and many bond funds) to increase dramatically. The fact that the 1-year & 3-year return on our bond fund poster was much higher than the 5-year return, also seems to confirm that the catalyst for its strong performance occurred mainly in 2008.

Although this fund had great historical performance, the most important consideration for new investors contemplating whether to invest in the fund or not was: how well it would perform in the future. Ironically, the dynamic between the rolling historical return of this bond fund and the cyclical nature of the bond market is very similar to the dynamic we saw in 2007 between our equity fund poster and the stock market. Sadly, many investors I talked with at the time hadn’t learned any lessons from 2007 and again shallowly focused only on the historical returns in large block print in our bond fund poster. In retrospect, those that were enticed to invest in bond funds like this one, in mid-2009, performed okay, but their return was much closer to the historical norm one might expect from a bond fund (as opposed to the double-digit returns they were hoping for). It’s also important to remember that many of these investors saw this bond fund as their ticket to redemption and hoped it would help restore their portfolios to their former glory. Below is an image to help illustrate why their intuition was incorrect:

 

The blue line above represents the price of iShares’ S&P/TSX 60 Index ETF (adjusted for dividends & splits). The green line represents the iShares’ Canadian Government Bond Index ETF, and the red line represents iShares’ 20-year US Treasury Bond ETF. The chart starts at the left showing only the TSX 60 ETF. As you can see, TSX 60 ETF starts dropping in the middle of 2008 and falls almost straight down for an entire year. Once the blue line reaches its lowest point in February 2009 I introduce the two bond ETFs to give you a sense of what a recovery would be like had investors either stayed the course and held on to their stocks (in blue) or swapped into bonds (in green & red). It is important to note, that had investors had the intuition to transition into bonds prior to the crash (or held a diversified portfolio) they wouldn’t have experienced such a dramatic loss. But that certainly wouldn’t have been possible for any investor who took their investment cues from posters, as the bond fund poster wasn’t even displayed until 2009.

The period between 2007 and 2010 played a crucial role in developing my understanding of market cycles, investor psychology, risk management and the important of due-diligence. Unfortunately, for many investors, that same period in history represents huge financial losses and emotional pain. It is important to note that similar posters to the ones displayed in my branch were also displayed in our competitors branches as well. I’m also not insinuating that there was any foul play with respect to the odd timing of the posters. We expect companies to want to advertise when their products are performing well. Markets tend to move in cycles, but ironically, the length of those cycles just so happens to approximately the amount of time it takes for many investors to take notice and get on board. This has the effect of pulling the rug out from those that are late to the party.

For almost a decade I’ve been pondering the events I witnessed as a bank teller between 2007 & 2010. I’ve come to the conclusion that: having a lack of financial literacy was what hurt regular investors most. Most people are not taught how to interpret technical and fundamental market data. When it comes to purchasing a consumer item most people find it easy to spot a deal, or a fad, but when it comes to financial products most untrained investors seem to reverse the two. The consequences of having a lack of financial literacy are amplified when emotion is involved. The mood of investors seems to mimic the cyclical nature of markets by oscillating between the emotions of greed and fear. I observed this first hand when so many investors rushed to invest in my branches equity fund at the top of the stock market just because they saw a poster showcasing how great their returns would have been had they invested five years earlier. Many of those same investors panicked in fear and sold out of their stock investments after experiencing dramatic losses, only to trade into GICs that paid almost zero return (but promised a “guarantee of principal”). Finally, some investors then missed out on one of the longest bull-markets in recorded history because they were either on the sidelines stuck in safer GICs or because they were lured into bonds by yet another poster showcasing how great their return would have been had they invested five years earlier.

For most people, investing is deeply connected to their present & future quality of life. That’s why it is almost impossible to completely separate emotion from investing. Having an understanding of financial literacy (or aligning with an advisor who is financially literate) can help investors temper their reactions to highly emotional situations. The other tool all investors should leverage is a solid financial plan. A strong financial plan can help investors to never lose sight of their goals. Its principles aren’t eroded by the cacophony of conflicting market commentary investors are subjected to on a daily basis. Although I’ve been studying markets and investing for about 15 years the most important lessons I’ve learned came from my short time as a bank teller observing how clients reacted to the posters on display during the beginning, middle and end of the 2008 Financial Crisis. Despite still being tempted by my own emotions during periods of market euphoria and hysteria, I’m reminded to stick with my financial plan and beware of the writing on the wall.

By Mike Fortunato, CIM®, FCSI®

image: https://www.flickr.com/photos/notionscapital/5455358198

 

Although the indices dipped slightly in the late summer of 2007, both the Canadian & US markets had recovered by October of that same year. During that same period at our branch, our equity mutual fund poster continued to be an attraction for many of our clients. I vividly recall how the double-digit returns on display sparked many conversations that ranged from transactional chit-chat to requests to speak with our advisors. As 2007 was coming to a close, excitement among our clients had reached its peak; little did they know that the rollercoaster ride was just about to begin.

Fast forward less than one year, to the summer of 2008, and the mood had certainly changed. The Canadian market, which showed positive signs in the spring of 2008 was back where it was a year earlier. The US market, on the other hand was doing much worse and was down approximately 15% from the level it was when the equity mutual fund poster first appeared at our branch. The mood of the clients was also beginning to shift. Those that were covetous a few months earlier were now much more cautious. My favourite client, the man who just a few months ago was excited to give me his weekly, bullish market prognostications, was now probing me about when I thought the market would rebound.

By early fall of 2008 things had taking a precipitous turn for the worse. Both the Canadian & US markets were approximately 30% lower than they were the preceding year. Any hope that was remaining at beginning of the summer had now transformed into panic. Much of the losses accumulated in those months in 2008 were concentrated in a few extremely volatile days. This took many investors by surprise and left them holding portfolios with massive unrealized losses. My branch was somewhat of a microcosm of what was happening on a global scale. The same clients, who just a year earlier were so intrigued by our equity fund’s potential return, were now desperately in search for any means to stop the pain.

In an effort to buttress their deflating economies, central banks around the world began aggressively lowering interest rates in their respective jurisdictions. During 2008 alone, the Bank of Canada lowered its key overnight rate almost 3% (from just over 4% all the way down to 1.5%). Although this rate easing would eventually sow the seeds of a slow recovery that would take about four years to materialize, its initial effects were to dramatically distort the fixed income markets throughout Canada. It was during this commotion that our branch eventually removed the equity mutual fund poster that had caustically arrived as the market was reaching its peak, about a year earlier. The new poster that replaced it, however, was no less ironic in its timing and implications; it’s caption read: “Guaranteed Investment Certificate”, and it offered terms that ranged from 1 year to 5 years.

At the time we were still in the middle of a market meltdown, and I can completely understand why banks would choose to remove the equity mutual fund poster that boasted double-digit historical returns. After all, those performance numbers were certainly no longer acculturate, and could easily spark resentment with many investors who were still experiencing the pain from the bear-market that had no end in sight. The idea of a guaranteed investment must have gleamed like a light beacon to the many clients that were watching their portfolios slowly evaporate away. Sometime during the 2008, I recall noticing that the other competitor banks also took similar actions by eventually replacing their equity mutual fund posters with GICs posters. Unfortunately for all investors, due to the dramatic shift in our yield curve, I don’t recall seeing any GIC’s offering more than 1.5% (regardless of the term). That is the nature of any market; when investors rush into a security, the price of that security rises. In this case, investors were rushing into an investment that offered a guarantee of principal. Speculation had taken a back-seat to safety, and that spike in the demand for safety had a tremendous effect on its cost: the cost being the fact that you would earn almost nothing for locking up your money for one to five years.

Beyond earning almost nothing, there was also a huge hidden opportunity cost embedded into those GICs due to the fact that your investment is locked up for the term of the GIC. As I mentioned in part 2 of this article, going back to 1956, the average bear-market in Canada & the USA have historically lasted around 9 to 14 months, and by the time it took both markets to drop about 30% from their 2007 high, an entire year had just about passed. So, on a historical basis, the bear-market that was causing our clients to panic was actually coming close to its end. But as is normal in both bull & bear-markets, most investors and commentators seem to believe that “this time will be different”. Looking back in hindsight, we can see that the bear-market during the 2008 Financial Crisis actually lasted about 11 months in Canada and 16 months in the USA, which was very much in line with the historical averages. So, for an investor motivated by fear, locking into a GIC for a long-term in the latter part of 2008 meant missing out on the recovery that followed.  

Below is graph to illustrate my point:

 

The blue line above represents the price of iShares’ S&P/TSX 60 Index ETF (adjusted for dividends & splits). The movement of that line is analogous to the movement an investor’s portfolio would undergone during the seven-year period between May 2007 – May 2014. As you can see, an investor would have experienced a dramatic loss early during the financial crisis between May 2008 – Feb 2009. The five other coloured lines are the theoretical return an investor would have received had they sold out of the market and immediately invested in a GIC paying 1.5% per year. The green lines represent investors who made that switch in June 2008 & August 2008. They managed to enjoy all the gains of the bull-market while also avoiding all the pain of the initial drop in 2008. Even the best investors rarely display such perfection in timing and foresight. It is important to note that just staying the course and riding the blue line eventually becomes the winning bet near the end of our chart (in May 2014), and shows a massive outperformance had I extended the chart all the way to present day (mid-2018, where GICs are still paying less than 2%). The red lines at the bottom of the graph show a more realistic representation of what a panicking investor might have experienced. After all, the bulk of the losses occurred in the span of just two months just after the summer of 2008. For most inexperienced investors, their capitulation would have probably occurred after that big drop.

As a bank teller during the Financial Crisis I was observing this dynamic play out in real time. The graph above displays blue, green and red lines, but to me, those lines represent actual investors I knew and interacted with on a daily basis. Some held onto their investments and rode out the storm and eventually recovered all their losses, while others threw in the towel at or near the bottom of the market and haven’t invested in equities since. Witnessing the forces of fear and greed in a Behavioural Finance context taught me valuable lessons about investment suitability, and the interaction between an investor’s time horizon and their risk tolerance, that I still leverage to this day. Many of the clients at our branch were lucky that they had relationships with our branches advisors as they were given guidance during the market turmoil. Unfortunately, any investors who took their cues from posters often found themselves invested in good securities, but at the worst possible time.

By Mike Fortunato, CIM®, FCSI®

image: http://theholyfinancier.com/beat-the-herd-mentality/

 

It was the early summer of 2007; I had just started my new job as a bank teller and had begun building relationships with my branch’s many regular customers. Our diverse customer base contained a wide spectrum of investor profiles whose experience ranged from starter to sophisticated and whose risk appetite ranged from skeptical to speculator. One thing they all had in common however, was that they were complete unaware of the looming Financial Crisis that was just around the corner. During those first few weeks, while settling into my new role, I recall that all the posters on our display wall contained what I would describe as boring advertisements of our various account types and fee structures. One day this all changed when a new poster became the centerpiece of our five-poster spread. I remember this all very clearly because this was the first time any client had ever asked me for more information about one of our posters. And for several weeks after its arrival that poster became the catalyst for many eye-opening conversations between myself and the inquisitive clients who just “had to know more” about it. What was on the poster? It was an advertisement for one our equity mutual funds. I actually don’t even remember the name of the fund. To be honest, however, it wasn’t the mutual fund’s name that had piqued the client’s interest. I’m certain of this because the only part of the poster any client ever inquired about were the three, double-digit, numbers centered on the poster in large, bright, bolded font under the corresponding headings of: “1-Year Return, 3-Year Return & 5-Year Return”.

The information presented on that poster was not an exaggeration. That particular equity mutual fund actually did deliver double-digit, annualized returns to its unit-holders for the past several years. But beyond eliciting a Pavlovian response, that information is of almost no use to an investor who understands the cyclical nature of markets. To be clear, I’m not saying that the bank was attempting to manipulate its customers through Bernaysian persuasion; in fact, anyone with a magnifying glass could clearly see that “past performance wasn’t indicative of future returns”. It is important to note that at the time I also had personal accounts at two other Big Five competitors and often visited their branches to conduct personal business. During those visits I observed that they too were usually displaying posters that advertised the same investment products as my bank. While their poster’s colour scheme was different than ours, the content displayed was usually quite similar.

A major component of my role as a teller was to refer clients who were interested in our products to our branch’s advisors for more information. Needless to say, my referrals really picked up the day we began displaying the past, double-digit returns of that equity mutual fund. Before introducing them to our advisors, our interested clients would often ask me a few cursory questions about the mutual fund and although I wasn’t in a position to answer many of their questions (for regulatory reasons) I did glean some insights into the mindset that they entered the advisor’s office with. As someone who had already been studying Behavioural Finance for the past few years, it was very easy for me to conclude from the nature of their questions that they were operating from a mindset tilted more towards greed verses fear. Of the dozens of clients that were interested, only a handful ever asked me about the risks involved with such an investment, and the vast majority were mostly concerned with seeing proof of the past performance, which was quite easy for our advisors to provide them. The only fear I ever detected came in the form of “fear of missing out” rather than fear of loss. It is important to also remember that, at the time, the market had been in an uptrend for the past several years and one only needed to flip to any financial news TV station to see the anchors proudly boasting that broad market indexes were too showing double-digit historical returns. I’ll never forget my favourite customer; an upbeat older gentleman who would visit our branch on an almost daily basis to give me his stock picks for the week. When I probed him as to why he liked those tickers he would parrot to me the target-price he saw online that morning as if the company was destined to trade at that exact price in the near future. While the mood during this time in history wasn’t quite the “irrational exuberance” that Greenspan had observed a decade earlier it certainly was an exciting time to be in the markets.

It wasn’t a mere coincidence that the arrival of the poster showcasing double-digit, historical returns came just a few weeks prior to the top of the market. This is actually quite normal and has less to do with some secret bank conspiracy and more to do with basic math and market dynamics. You see, markets (like the stock, bond or real estate markets) tend to move in a cyclical fashion. Generally speaking, over very long time periods, markets usually tend to move in a positive direction, however, over the medium & short-term we tend to see prices oscillate between peaks and troughs. Using price data all the way back to 1956, we can see that there were 12 stock market cycles in Canada and 11 the USA (peak to peak including our current bull-market). During that time, the average bull-market lasted 52 months and 48 months respectively while the average bear-market only lasted 9 months and 14 months respectively. But as the two graphs below illustrate, we can see that the duration of the average bull-market has increased significantly in more recent history (from 1980 till present). It would appear that more modern bull-markets tend to last somewhere between five and ten years in both Canada and the USA.

Source: mackenzieinvestments.com Original Source: Bloomberg March 2018

As we can see, the return from equities is far from steady. Over the long-term we can forecast growth, however, that growth is traditionally delivered in waves that last between five and ten years. This is why it is incredibly dangerous to rely on historical growth (especially when measured in 3-year & 5-year rolling periods) to predict where the markets will go in the near-term. Mathematically speaking, if a market rises for five years or more before falling, then that market’s 5-year historical return will be at its highest level precisely at the moment before it is about to crash.

To illustrate this point, I’ve created a theoretical market price series that runs for 40 years. The price of this series (the blue line) starts at $1000 in 1978 and ends at $4448 in 2018. The market follows a simple, random progression where it increases for seven straight years with each year’s increase being randomly generated between 5% and 15%. Then, on each eighth year, the price decreases by a random amount between 30% and 50%. This creates a 40-year market price series (with repeating cyclical periods of eight years) and has an average annualized total growth of about 4%. If we add in a 2% dividend, we have a somewhat realistic model to work with.

On top of this price series I’ve overlaid its rolling 5-year return, rolling 7-year return & rolling 10-year return in orange (in three separate graphs). As you can see, the historical 5-year, 7-year & 10-year return is at or close to its peak precisely as the market, in blue, is about to start falling. There is one other noteworthy observation: according to this chart, the best times to buy this market also happened to be when the rolling 5-year, 7-year & 10-year historical return was at or near its lowest points. In some cases, the rolling, historical return was actually negative even though the market had bottomed and was about to rise for seven consecutive years.

 

If this artificial price series seems too unrealistic, I’ve also replicated the same experiment using actual prices data from both the S&P 500 between the years of 1990 – 2018 and the S&P TSX60 with price data from 1988 - 2018. Again, we can see that high points in the historic rolling 5-year returns (in orange) correlated well with precipitous drops in the value of the market index. Also, investors who invested when historical returns were low were rewarded for their contrarian courage.

 

 

As you can see from the two diagrams above, there is a short window where the market’s rolling historical 5-year return is too high for a bank’s marketing team to ignore, given that their goal is to attract new business through visual advertising. You can’t really blame them either, because most clients would probably ignore any poster that displayed lackluster past returns, even though we have now proven that it might be in their best interest to take that information into consideration. The mathematical relationship between a cyclical market and its rolling 5-year returns, combined with basic phycological facts about human greed & fear offer us a complete model explaining why equities appeared so attractive to so many people at the worst possible time. No conspiracy theories required!

By Mike Fortunato, CIM®, FCSI®

 

image: http://metuchenliving.com/why-do-we-sell-low-and-buy-high/

Eleven years ago, in the summer of 2007, I landed my first finance related job as a bank teller for one of Canada’s Big Five national banks. Like most entry level roles, being a bank teller taught me valuable lessons about customer service, organization, problem solving, and teamwork. It also gave me a great introductory view of the broader finance industry that I still work in today. When I started my career at the bank, my goal was to eventually work with investments. Now that I’m a member of a portfolio management team I still find myself leveraging knowledge about economics, markets and investments that I picked up while I was a teller over 10 year ago. The most important lessons I learned however, didn’t come from the training or mentorship I received, but instead came from simply observing our clients’ reactions to the global financial system that was collapsing around us all during a period that we now call: The Great Recession (or 2008 Financial Crisis).

Just a few months after processing my first bank deposit I watched the world’s equity markets fall into complete pandemonium. During the year and a half that followed, the world experienced a terrifying bear-market where stock prices plummeted from all-time highs to levels not seen for almost a decade. Being a teller during that time was like having a front row seat to watch the panic unfold. On a daily basis I observed my branch’s customers and advisors trying to make sense of chaos. I remember thinking to myself at the time, “how is it that so many people didn’t see this coming?”. In the weeks leading up to the crash I recall that many analysts on the financial news, and most of the investors I spoke with, were actually quite bullish. Their positive outlook even continued into the first few months of the crash, when each new market low was often celebrated as an opportunity to double-down in anticipation of a correction bottom that never seemed to arrive. While trying to make sense of all that was unfolding I noticed a phenomenon that gave me tremendous insight into the interplay between market fundamentals and basic investor psychology: the most expensive and riskiest investments are often the most attractive to investors who don't understand the cyclical nature of markets.

As a bank teller I was stationed at the font of the branch directly facing a wall of promotional posters that the bank had setup to drive various product offerings. A large part of my role involved answering client’s questions about those posters. The bank’s marketing team would periodically change the content advertised on the posters to coincide with whatever new campaign the bank was promoting at that time. Every time the posters changed, the bank’s clients would come to me to inquire about the writing on the wall. Being on the front lines literally put me in the best position to observe both the timing of the bank’s investment offerings and the client’s reaction to them. Overlaying both these observations against the backdrop of The Financial Crisis as it was unfolding, was a revelation into the powerful micro-economic forces that drive market cycles. Since acquiring this knowledge 10 years ago, I’ve witnessed this powerful phenomenon play out several other times in many other markets: the stock market, forex, commodities and multi-unit residential real estate market. The next three instalments of this article will focus specifically on the how this dynamic unfolded: during the bull-market leading up to the crash, during the crash itself and finally, during the recovery that followed.

By Mike Fortunato, CIM®, FCSI®

image:FHM.com - Warner Bros.

 

This is the fifth and final instalment in our five-part series about risk. In the previous instalments we introduced three types of risk that investors need to consider when trying to achieve an investment goal: Volatility Risk, Shortfall Risk and Absolute Risk. We then took a deeper look at each type of risk and discussed ways to manage them. In this last instalment I want to illuminate the relationship among these three risks and suggest some strategies that exploit these connections to lower overall risk and help us reach our goals.

Let’s quickly summarize each risk, and my recap my tips for managing them:

Volatility Risk refers to the potential fluctuations in value an investment may experience while owned. It doesn’t represent a realized loss (or gain) unless that investment is sold. Generally speaking, the investments that have historically provided the highest potential return also tend to have higher volatility, whereas the investments with the lowest volatility have tended to have the lowest return. I believe that Volatility Risk is best managed by ensuring your portfolio’s volatility is appropriate for your time horizon. Investors with longer time horizons are in a better position to accept more Volatility Risk, because there is adequate time for their portfolio to recover from a “paper-loss”. Conversely, if an investor has a shorter time horizon, then they should opt to hold investments that are less volatile. By properly constructing a portfolio that complements their time horizon, investors create a situation where they are insulated from the negative effects of volatility. The benefit of managing Volatility Risk with an appropriate time horizon is that investors don’t have to limit security selection to low volatility choices investments that come with lower return; investors, however, do need to be mindful that unplanned emergency withdrawals will reintroduce the effects of Volatility Risk back into the equation.

Shortfall Risk is the potential of not reaching an investment goal because the actual rate of return received was less than the expected rate of return. Beyond achieving a satisfactory rate of return, which goes without saying, there are two things investors should focus on that will help minimize shortfall risk:

1. Striving to contribute more money towards the goal, as frequently as possible.
2. Making sure their goal is realistic given their time horizon and situational constraints.

Like Volatility Risk, the best ways to combat Shortfall Risk come from behaviours that go beyond security selection and instead focus on the larger picture of the investors goal and plan to achieve it.

Absolute Risk is the risk of experiencing some sort of personal catastrophe or emergency. It is unlike the above two risks because it is only indirectly related to the investor’s goal; however, it has the ability to derail an investment plan because it may force an investor to stop saving, or worse, withdraw from their plan. The best way to combat this risk is to put yourself in a situation where it won’t affect your investment plan. This can be accomplished by insulating your investments from a personal emergency by having both an emergency fund and adequate insurance.

As you can see these three risks are huge obstacles that investors must navigate if they are going to reach their goals. Although these risks impact different aspects of an investor’s plan, they are connected in ways which can be exploited. One common thread these risks all share is that they can all largely be managed through how an investment plan is structured in relation to the goal it is trying to achieve.
Prioritizing these three risks is the key to combating them. Even though Shortfall Risk is the most important of the three risks I tend to make it my last priority because it can be largely solved by first controlling the other two risks. As we saw above, beyond achieving a satisfactory rate of return, two habits that minimize Shortfall Risk are: 

1. Striving to contribute more money towards the goal, as frequently as possible.
2. Making sure the goal is realistic given the time horizon and situational constraints.

Both of these items are staples of a solid financial plan; however, the first habit can be disrupted if an Absolute Risk materializes. More specifically, investors might be compelled to tap their investments for funds in the event of a personal emergency. Viewed in this way, Absolute Risks are actually a potential cause of Shortfall Risks. By having an emergency fund and adequate insurance investors not only mitigate the effects of Absolute Risks, but also help indirectly minimize Shortfall Risks.

The second habit that helps minimize Shortfall Risks is making sure that investors’ goals are realistic given their time horizon and situational constraints. As you may recall, however, the exercise of taking a broad view of an investment plan in the context an end goal is an indispensable tool that investors can use to insulate themselves from Volatility Risks. My view has always been that rather than run from volatility, investors should first see if they can create a financial plan that can embrace volatility and the return that can be correlated with it. The only caveat of this approach is that investors need to ensure that they can adhere to their time horizon and not be compelled to alter their investment plan to cover a temporary life emergency with investment funds. But we already addressed this earlier by first focusing on Absolute Risk, through having an emergency fund and insurance.

Below I’ve created a flow-chart to help illustrate how I mentally prioritize these risks. This chart isn’t the only solution to the problem of managing these risks, it just happens to be a structure that has worked well for the financial plans I’ve help create. Starting at the top the chart flows towards the risk that represents ultimate failure: Shortfall Risk. However, you will notice that Shortfall Risk is the last step in the flow-chart because it is largely combated by first solving the other elements in the chart.

In conclusion, I believe that Volatility Risk, Shortfall Risk & Absolute Risk are the three most important risks that stand in the way of investors reaching their goals. Individually these risks have the potential to hurt an investment plan, but also, when mismanaged, their negative effects can be compounded. By prioritizing these three risks investors can leverage how these risks are interconnected and focus on only a few crucial habits to combat their negative effects. Instead of juggling three risks investors can instead view this as a single exercise in creating a solid financial plan that complements their financial goal. These risks will still exist; however, a solid plan will help investors steer clear of those risks while constantly keeping them in view.

 

 

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros.

 

In the last two instalments in this article about risk we took a closer look at Volatility Risk & Shortfall Risk. Today I’m going to breakdown my thoughts on Absolute Risk.

Absolute Risk

When I refer to Absolute Risk I’m talking about the type of risk that is often associated with insurance. Absolute risk is any risk where there is no possibility of gain; there is only the risk of loss. Examples would include events like: health issues, losing a job, or any sudden, unplanned expense. Although Absolute Risk doesn’t affect an investor’s portfolio directly; it does damage an investor’s overall financial position, and usually impacts their investing behaviours.

I’ve witnessed many investors drastically alter their investment plan after experiencing an unexpected loss. For example, after losing a job, many investors frequently stop contributing to their retirement accounts, and some investors even go so far as to withdrawal from their RRSP triggering withholding taxes and other penalties. As we saw in the last instalment, one of the most important variables in reaching a financial goal is saving regularly; and this is where Absolute Risks can do the most damage. Your money can’t grow if it is not invested, so during an emergency, time spent on the sidelines that isn’t automatically contributing towards your goal will equate to more time needed to reach your goals. Also, withdrawing a sizeable portion of your goal to cover an emergency can be even more devastating because not only are you not contributing, but now there is less left in the pot to grow.

There is one more hidden risk that can result from an Absolute Risk materializing. An Absolute Risk can expose you to unplanned Volatility Risk. As I mentioned in the second instalment of this article: when properly managed, Volatility Risk is only a threat when investors are forced to sell their investments at an unplanned time. When such an emergency occurs, it might force a sale at a price lower than what they expected. This will exacerbate the negative effects towards their investment goal because they’re forced to sell more shares than expected, which adds more time to their recovery. Although this may seem like an unlikely doomsday scenario, it is actually a reality for many investors, as most employers are forced to lay off employees when the economy is doing poorly, which also tends to be when the investment markets are performing poorly.

Many investors have a poor plan, or worse, no plan to manage Absolute Risks. In fact, most of the investors I’ve encountered view their investment accounts as quasi-emergency funds: their only alternate source of savings in the event of an emergency. This is the reason why Absolute Risk can really wreak havoc to an investor’s investment goals. The best way to manage Absolute Risks is by having both an emergency fund and having adequate insurance. The only way to ensure that an emergency will have no impact on your investments is to completely insulate your investments from that risk. I always encourage investors to compartmentalize their investment accounts, and mentally forget about them as a potential source of emergency cash, but this is easier said than done when a real emergency strikes. That is why investors should have an emergency fund and proper insurance before they start investing. I could write a whole article about how much emergency cash and insurance someone should keep on the sidelines, but a good rule of thumb would be to make sure the amount saved will realistically cover the cost of an actual emergency.

Absolute Risk was the third and final risk I wanted to discuss in this series. Although they don’t directly impact your portfolio, they can hurt your financial goals indirectly. In the next, and final instalment of this article I will discuss how all three of these risks are interrelated, and a strategy that investors can use to manage all three.

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros.

 

In the first instalment of this article we introduced three types of risk: Volatility, Shortfall and Absolute. In the last instalment we took a closer a Volatility Risk. Today I’d like to examine Shortfall Risk and give you my perspective on how to best manage it.

Shortfall Risk

As you may recall, Shortfall Risk is the risk that an investment’s actual return will be less than the expected return needed to meet a financial obligation. Another way to think about shortfall risk is to say that it is the risk of falling short of an investment target or goal. To me, this is the most important risk because when it occurs it means you’ve failed to achieve your goal in your desired time frame. Oddly though, many investors don’t start seriously focusing on this risk until it is too late.

When it comes to shortfall risk I also think many investors are focusing too much on the variable that is the hardest to control: obtaining a high rate of return. Once a reasonable rate of return is achieved it becomes increasingly harder to put in more research and get more out in terms of added return. The law of diminishing returns seems to also apply to investment returns. Sure, with proper due diligence and adherence to sound portfolio management best practices it is possible to obtain a strong long-term rate of return, but far too many investors are banking on achieving double-digit returns to reach their long-term goals. I’m not saying that is impossible to achieve consistent double-digit returns, but it simply isn’t a realistic expectation for most investors.

Many investors would be better served if they focused less on rate of return and instead focused more on the other variables that they have more control over:

• The amount they contribute towards their goal.
• How frequently they contribute to their goal.
• How reasonable their goal is in relation to their time horizon.

Just to be clear, I’m not saying that striving for a high rate of return isn’t important, in fact, the previous instalment of this article talked about how I feel that under the right conditions, rate of return is more important than Volatility Risk; what I am trying to say is that investors need to understand what will impact their financial goal the most.

Here is an example to illustrate how important saving is in relation to rate of return. Let’s compare two different investors: Ray & Warren who both invest for a 20-year period. Ray earns a higher rate of return than Warren: 8% per year, but he saves less on an annual basis: only $600 per year. Warren, on the other hand, earns a lower rate of return at only 6% per year, but happens to saves more on an annual basis: $800 per year. Let’s see whose portfolio grows more after 20 years.

As you can see, even though Warren is earning a lower rate of return, he still comes out ahead because he was saving more each year. Also, we only used 6% as our forecast for Warren, which has a higher chance of materializing in real life instead of the 8% used for Ray. Certainly, it is possible to obtain a long-term return that is higher than 6%, but it is always helpful to be conservative in your estimates.

The other variable that investors have control over is how realistic their goal is in relation to their time horizon. I’m not going to suggest a specific formula to generate a realistic goal, because that would be an entire topic on its own, but I will highlight some general principles that are important to consider. The shorter your time horizon, the lower expected return you should use in your forecast. The reason for this is because you will want to limit your exposure to Volatility Risk if you don’t have the time to ride out the bumpy ups & downs of the market, and as I mentioned in the previous article, generally speaking, there are some trades-offs in return that come with less volatile investments. Yes, there are advanced portfolio building techniques you can employ to try to maximize your growth while keeping your volatility in check, but as we saw in the above example a few extra percent of growth each year is less important than trying to find ways to save more towards your end goal – especially with shorter time horizons. Also, extra return will help a lot over longer time horizons, but as we learned in the previous instalment of this article, exposure to volatility risk becomes less important when your time horizon is shorter.

In summary, Shortfall risk is one of the most important risks investors face because it is literally the risk of failing to achieve their goal. The best way to minimize Shortfall is to first ensure your goal is realistic in terms of the rate of return you need to assume to reach the goal within your time horizon. Then do everything you can to maximize how much you save and contribute to your goal over time. These are the variables you have the most control over. In the next instalment of this article we’ll examine the third and last type of risk: Absolute Risk.

By Mike Fortunato, CIM®, FCSI®

image:FHM.com - Warner Bros. 

In the first part of this article I introduced three types of risk: Volatility, Shortfall and Absolute. Today I’d like to continue from where we left off. There are literally dozens of other categories and subcategories of investment risk, but I’m going to restrict our discussion to just these three because many of the other risks I have not mentioned are actually related. Now that we’ve limited our discussion to just these three, I’d like to describe my observations regarding how many investors view and consider these risks, and I’ll offer an alternative point of view for consideration.

Volatility Risk

As I already mentioned, volatility risk is expressed by an investment’s standard deviation. It is a measure of how the price of an investment fluctuates over time. There are however, a few important aspects of this type of risk that I think are very important to mention: 


• When we measure an asset’s standard deviation, we are measuring past fluctuations in price.
• An investment’s historical volatility can give us some insights into how it will behave in the future, but there is no guarantee that an investment’s future volatility will be the same as its historical volatility.
• Standard deviation measures absolute changes in price and treats rising prices and falling prices the same, but investors are usually more concerned about the negative consequences of falling prices verses the positive consequences of an investment rising in value.

There is one aspect to volatility that I think is most important: when an investment’s market price falls in value it doesn’t necessarily mean you’ve lost any money, just like when an investment’s market price rises you haven’t necessarily gained any money. In order for an investor to realize an investment’s loss or a gain, they first need to sell their investment, and until they do sell we refer to their position as having a “paper-loss” or “paper-gain”. Volatility, as you recall, only measures the magnitude of an investment’s market price fluctuations. So simply holding a volatile investment has no real bearing on what your future loss or gain might be. In our illustration above, both ABC & XYZ ended at the same value: had both of them been sold on January 31st, the return for the investor would have been the same. Volatility, in this example, actually had no bearing on the rate of return. Volatility could have potentially affected the results if the investor had to sell either investment at some time between January 1st and January 31st. If for example, we had to sell on January 10th, XYZ would have experienced a greater loss than ABC.

 

In the scenarios I just described volatility only really matters in a situation when investors are compelled to sell their investment early during the chart. I’m not saying that all volatile investments eventually move towards a paper-gain, but what I am trying to highlight is that under certain conditions & assumptions other factors matter much more than volatility. Those other conditions & assumptions are:


• Your time horizon should complement your portfolio’s volatility.
• Your investments need to have a reasonable long-term rate of return.
• You are not compelled, for whatever reason, to prematurely sell your investments before your stated time horizon.


You might be thinking, why not just find an investment that has no volatility (basically just a straight diagonal line on the chart)? Those types of investments do exist; however, history has shown that there is somewhat of a trade-off between return and volatility. A GIC would be an example of an investment with basically zero volatility, but your real return (after-tax, inflation-adjusted) would be close to zero as well. Generally speaking, the market considers volatility when pricing assets, and assets that tend to be more volatility are typically valued in a manner that compensates investors for taking on the excess volatility risk. The end result is that, generally speaking, the assets that carry the most volatility also tend to carry the highest chance for long-term return. Investors who are cognizant of these facts can exploit them to their benefit by opting to hold the investments that provide a volatility discount while ensuring that their holding period insulates them from the potential negative effects of Volatility Risk.

Although understanding an investment’s potential volatility is important, I think some investors are paying too much attention to it for the wrong reasons. Many investors are conflating volatility with only losing money, and forgetting that the most volatile asset class: equities, tends to have the highest long-term returns. I can understand why investors are worried, as we all recall past high profile stocks that have gone bust, but that type of risk can be mitigated through proper diversification and fundamental due diligence. In my opinion, investors would be better served by trying to make their portfolio’s volatility complement their investment time horizon. Although it is logical to invest in the assets that will provide the best return over your time horizon, and ignore volatility that won’t affect their goal, many investors still find it challenging to watch the “paper-value” of their portfolios temporarily lose value. This often causes investors to alter the optimal composition of their portfolios in favour of an allocation that will provide less long-term return but with less overall volatility. Being overly conservative, however, is still better than the two other likely alternatives: overreacting and selling during a market drawdown, and, not investing at all.

I’ll end this instalment with one final note: Above, I presented a general concept about how I believe investors can maximize returns by ignoring volatility that doesn’t affect their long-term return. The tricky part is selecting investments that will provide that long-term return. I’m not suggesting that volatility causes investments to have high returns, but rather, I’m saying that often the investments with the best return might also have higher volatility. The goal of the investor should be finding the investments that will perform the best in their portfolio, regardless of the volatility of those investments: as long as they can tolerate the ups and downs without overreacting, and are not dependant on the portfolio for income or emergency cash.

In the next instalment I’ll take a closer look at Shortfall Risk, and hopefully illuminate some ways it can be managed.

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros. 

 

What is risk? What does it mean for something to be risky? Well, the dictionary defines “risk” as: “a situation involving exposure to danger”, and defines “danger” as: ‘the possibility of suffering from harm’. Okay, so risk seems to involve two parts: the element of a negative future consequence, as well as a probabilistic element. But I didn’t need to look up “risk” in the dictionary. After all, everyone intuitively grasps the concept of risk. We all experience risk in our day to day lives. There are physical risks like: driving in a car, walking across the street or riding on a plane or boat, but there are also risks that don’t involve physical harm like: switching careers, starting a new relationship, or gambling. All these examples are considered risky even though the consequences and probabilities are quite different. Clearly, risk can take on many forms. As a portfolio manager and advisor, I’m most concerned with how risk impacts wealth creation and the investments of my clients who have entrusted me with their financial future. 

We’ve all heard the phrase: “investing involves risk”, but just like everyday life, risk, as it pertains to wealth management and investing, can take on many different forms. If you ask several people to define “risk”, in the context of investing, you’ll likely receive a diverse set of responses. You’re also bound to hear contrasting opinions as to how to best combat or control those same risks. In this article I plan to illuminate the concept of “risk” and offer some advice on how it can be managed. To tackle this topic, I’ll first need to thoroughly define what I mean by risk, from a wealth management perspective; then I’ll share my observations of how some investors view risk, and finally, I’ll share my own insights and ideas on risk management. It is important to note that there are many varying opinions on how to best manage risk; my views are not necessarily the best, but rather, I’m hoping to offer a different point of view from what is often said about this topic.

There are many different categories and subcategories of risk that affect investors, but for the purpose of this discussion, there are three types that I want to focus on:

1. Volatility (sometimes referred to as Variability, Volatility Risk, or sometimes just Risk)
2. Shortfall Risk (sometimes referred to as just Shortfall)
3. Absolute Risk (sometimes called Pure Risk)

Although these three types of risk are different, they are deeply interconnected to both an investor’s portfolio and financial plan. My goal is to shed some light on those connections and give both investors some new insights to consider.

Volatility:

When I say volatility, I’m referring to fluctuation of the price of an asset or value of portfolio as a whole. Volatility is usually measured using “standard deviation”, which measures the dispersion of a data set from its mean or average. Put more simply, volatility refers to the magnitude of the past ups and downs of an asset. For example, in image below we see two different investments: Investment ABC & Investment XYZ. The blue line traces the growth path of those investments over the same time frame. The grey line represents their average growth. As you can see, both Investments have the same average growth: that is, they both start and end at the same value. However, XYZ experienced a bumpier ride, as its ups & downs were twice the size of ABC’s ups & downs. In this scenario, we would say that XYZ was twice as volatile as ABC. We would also say that historically, XYZ carried twice the volatility risk of Investment ABC.

 

Shortfall Risk:

Technically speaking, shortfall risk is the risk that an investment’s actual return will be less than the expected return needed to meet a financial obligation. Another way to think about shortfall risk is to say that it is the risk of falling short of an investment target or goal. For example: the investor below had the goal of reaching $100,000 in seven years. Unfortunately, she was only able to reach $60,000 after seven years of investing. They now had to make choice: settle for only $60,000 or continue to save & invest and extend her time horizon.

Absolute Risk:

When I refer to absolute risk I’m talking about the type of risk that is often associated with insurance. Absolute risk is any risk where there is no possibility of gain; there is only the risk of loss. Examples would include events like: health issues, losing a job, or any sudden, unplanned expense. Absolute risk may not affect an investor’s portfolio directly, but it can damage the overall financial position of the investor, which often impacts their investing behaviours.

Now that I’ve introduced these three related risks, in the next instalment of this article will dig deeper into these three types of risk, and I’ll share some best practices I follow when trying to manage these risks while building wealth for my clients.

- By Karlene Antoine

You may realize by now that employer pensions and federal government benefits may not get you comfortably through your retirement years. More so if you are accustomed to earning a lot and would like to keep up your lifestyle or you plan to explore the world when you retire.

Added to that, Canadians are “living and staying active longer”. This increased longevity and activity comes with higher spending rates that require heavier nest eggs.

How can you prepare:

• Examine the time horizon of your investment. Consider your age and determine how long and how much you have to set aside withstanding your current financial status. Consider all your other financial goals or commitments for example: mortgages, education, and kids. Additionally, be mindful of emergency expenses that may arise before and after retirement.
• Research different types of investments and investment portfolios to find the one that is most suitable for your time horizon and your goal. Some investments are geared toward long-term investors while some are geared toward shorter-term investors and may have varying levels of risk depending on your age, for example.
• Find a balance between your budget and your spending habits to align with your earnings and your retirement plan. Automate your investment contributions to go directly to your investment account every month to ensure that you make it a priority.
• Evaluate your performance periodically to ensure that you are on track to achieving your desired amount for retirement. Be cognizant of ever-changing factors such as new laws, federal benefits, investment types or inflation that can have major positive or negative impacts on your nest egg.

 

The bottom line

No matter what type of investment you choose, or investment account (TFSA or RRSP or other), it is important that you revisit your retirement plan to make sure that you hit your target and not miss it. No plan is set in stone, be committed to improving your financial literacy to ensure that you are maximizing your reserves.