The only free lunch in cutting risk

Investing is rarely about making an all-in bet on just GICs or aggressive stock funds.

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The Investor Education Fund’s study of risk released today gives investors of all temperaments plenty of food for thought. While it surveyed more than 2,000 Canadians of various ages, net worths and geographic locales, most of the data reinforces the basic concept that risk and return are tied at the hip. To get sizeable potential investment returns inevitably means embracing more risk, which in turn means occasionally suffering outsized investment losses. Conversely, if you want to play it safe to minimize the chances of loss, then perforce you must also limit the potential upside.

2014 market jitters will test investors’ stated risk tolerances

The study was conducted by The Brondesbury Group in September 2013 and is being billed as the first major portrait of investors’ responses to investment risk since the 2008-2009 market meltdown. It’s ironic that the release of the findings comes just as global stock markets are starting to suffer from some major volatility, as they have ever since the new year began. If it’s true there’s sometimes a disconnect between what investors state their risk tolerance to be in surveys of this kind and how they actually behave in the face of uncomfortable market turndowns, investors may now be receiving an object lesson in the difference between theory and practice.

In real-life investing, very conservative investors gravitate to low-risk vehicles like Canada Savings Bonds and Guaranteed Investment Certificates, although interestingly the almost-comparable money market mutual funds are seen as a kind of gateway to riskier forms of investing: once you’re in a money market fund you’re just a quick switch away from equity mutual funds, which is where investors look for more return and of course higher risk.

Most serious investors I know have minimal exposure these days to CSBs and indeed the survey finds CSBs cited as “the worst performing product” by over a third of survey respondents. Of course, if the current market meltdown drags on much longer, those in CSBs that barely generate a real return net of inflation will be happy to be dodging losses of 10, 20% or more that are being inflicted on those who are net long the stock market.

Conversely, the “best performing” products cited in the survey are investment funds and Canadian stocks (presumably, a Canadian equity mutual fund or Canadian equity ETF qualifies on both counts and should therefore be “super performing.”) Such products also tend to be owned for relatively longer time periods by investors accustomed to riding out short-term storms.

Diversification and asset allocation

What didn’t seem to be raised much in the survey are topics like the efficient frontier, diversification and asset allocation, a point that Investor Education Fund President Tom Hamza concedes could have been played up more. (IEF is an OSC initiative that provides retail investors with independent,  unbiased financial education). For most investors, at least the type who read and act on the editorial content of MoneySense, investing is rarely about making an all-in bet on just GICs or only aggressive stock funds. Most of us have exposure to multiple types of investments with varying risk: this is of course the classic exercise in “asset allocation” that any financial adviser would address with clients. As Hamza noted in an interview, “people don’t generally put all their eggs in one basket.” In fact, the financial industry usually gives clients risk tolerance questionnaires that in many respects resemble the one that was the basis for the Brondesbury study. After determining whether you are in fact a very risk averse conservative investor or a highly risk tolerant “aggressive growth” investor, or a balanced investor halfway between these extremes, an adviser would generally try to match the client risk profile to the stated long-term investment goals; then he or she would find the investment solutions that will achieve those goals without subjecting the investor to more risk than they’re equipped to tolerate. The resulting document is usually called the IPS, or Investment Policy Statement.

The only free lunch there is in investing is diversification, which is why my office wall still features a chart from Franklin Templeton called “Why diversify?” It shows that in any given year, no one asset class is guaranteed to outperform or underperform. In 2013, U.S. stocks reigned supreme but in 2008, U.S., global and Canadian bonds were about the only type of investment that did not suffer double-digit losses.

The year 2014 is still young but it’s certainly looking like it’s shaping up to be much different than 2013. This study of investor risk, behaviour and beliefs couldn’t be timelier.

 

 

 

 

 

3 comments on “The only free lunch in cutting risk

  1. There’s a very interesting article by Michael Kitces about the apparent disconnect between stated risk tolerance and investor behaviour, which posited that it wasn’t risk tolerance that changed when investors acted in a way contrary to their statements, it was their perception of actual risk; that is, with markets going nowhere but up all through 2013, investors might believe that Canadian ETFs were “safer” investments than they really were, and therefore, rather than being motivated by greed to take on more risk than they were comfortable with, believed themselves to be investing with exactly as much exposure to risk as they were tolerant of.

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