Avoid unnecessary risk

Overeager investors need to temper keenness with caution.

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From the September/October 2013 issue of the magazine.

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So you’ve decided to get in shape. Good for you. But, please, heed the advice of those who have gone before you with unchecked enthusiasm: start slowly. Whether your new pastime is racquetball, running or rock climbing, the potential for injury is greatest when you dive in recklessly. It’s best to build up your strength and stamina first.

Overeager investors also need to temper keenness with caution. Putting too much money into risky investments will also lead to pain. Unfortunately, it’s a lot harder to learn from others’ financial injuries. Recognizing your hobbled coworker overdid it at the gym is easy. (“Note to self: don’t try squatting twice your body weight like Larry in accounting.”) But in the investing world, people only let you know about their successes. “If you’re at a dinner party, nobody hears horror stories from their friends who did something foolish with their portfolio,” says Jamie Golombek, CIBC’s managing director of tax and estate planning.

Single stock purchases are one of the most common and costly mistakes made by impulsive DIY investors. A diversified portfolio needs a minimum of 20 to 30 stocks, preferably more. Loading up on one or two can make you vulnerable to losing a large chunk of your assets. “I often see proper asset allocation being ignored by people who are managing their own portfolios and feel they have some special insight on a stock,” says Toronto fee-only planner Jason Heath. “But these days stock markets take into account information and data within a matter of seconds. So by the time you hear a little tidbit about something it’s too late. For the most part, that stock has already priced in that information.” More often than not, Heath says, investors who load up on a single company are simply chasing past performance.

Even otherwise prudent investors can unknowingly take on too much risk by making big tactical moves based on current market conditions. For instance, with equities on fire and bonds trickling out meagre yields, Jason Wale is questioning whether he should even bother with the fixed-income portion of his portfolio right now. “Given the current record low interest rates and our time horizon of at least 20 years, does it make any sense to invest in bonds at all?” asks Wale, who lives in Comox, B.C.

It sure does. You don’t hold bonds in your portfolio because you expect them to outperform stocks. They’re there to lower volatility, and to provide a safety net when stock markets tank—as they inevitably will during your investing lifetime. Even in the current economic landscape, bonds still play a role as stabilizers. “You never know when a bear market is going to come,” says Dan Hallett, director of asset management at HighView Financial Group in Oakville, Ont. “Bonds will reduce your losses and give you the flexibility to buy more stocks when prices are down. You have the ability and the resources to rebalance at that point.”

That was never more true than during the global financial crisis of 2008–09. Stock markets around the world fell by as much as half, but government bonds rose sharply and offset some of those losses. And any investor who rebalanced in 2009 enjoyed a huge recovery in the years that followed.

Investors considering holding 100% of their portfolio in equities have to ask themselves if they really have the stomach to watch their investments go up and down like a yo-yo, and to avoid selling in a panic during one of those dips. The fact is, an all-stock portfolio seems like a good idea when markets are on a tear, but it’s a wild ride for even the most risk-tolerant investor.

As pioneering value investor Benjamin Graham put it: “No portfolio should ever have more than 75% in stocks or less than 25% in stocks.” Decades later, that’s still good advice.

All this doesn’t mean responsible investors can’t make room for a little bit of speculation—as long as they have a strong financial foundation. If you genuinely enjoy trying to pick the next hot stock and you want to set aside a small portion of your portfolio to scratch that itch, that’s fine. But never use more than 5% to 10% of your portfolio to speculate, advises Vancouver fee-only adviser Ian Black. If you’ve carved out a small portion of your portfolio to chase the next Apple or Google, you’re playing with fun money and nothing more. “That’s not investing,” Black says. “That’s gambling.”

Complete all 10 steps for optimal fitness!

Step 1: It all starts with a plan

Step 2: Exercise regularly

Step 3: Eat a balanced diet

Step 4: Avoid unnecessary risk

Step 5: Reduce the fat!

Step 6: The wrong kind of supplements are dangerous

Step 7: Weigh yourself regularly

Step 8: The wrong kind of prepackaged food is dangerous

Step 9: Avoid the fads!

Step 10: Get the right help

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