Q: A friend of mine has inherited $50,000 and wants to invest it. This person will need $10,000 by next year, $20,000 in 5 years, but the remaining $20,000 has no near future need, so she plans to hold it for greater than 15 years. How would you invest this money? What kind of asset allocation would you use? Can you please together a simple and fundamental financial plan on how to allocate this $50,000?
A: At first glance, this looks like a simple question, but it’s actually quite complex. To start, the $10,000 that will be needed over the next year should go into an investment that’s very safe, such as a GIC or other deposit that has a certainty of maturity value.
But the answer to the two $20,000 amounts depends entirely on the tradeoff you are willing to make regarding risk and return. This information, in my experience, can only be gained through discussion in person with someone who can help you look at the entire picture as well as help you evaluate all your options.
Such conversations with novice investors in my office go roughly like this:
The only measure of investment return is the preservation of purchasing power after inflation. Equities—shares of companies—have been shown by history to generate, over periods of decades, returns in the range of inflation plus 6% or 7%; a return of 7% will double your purchasing power every 10 years. So over say 20 years, $20,000 would become $80,000. This fabulous return comes at a significant cost: the market value of equities declines by an average of 14% in any one year, and seven times since WWII has declined by more than 20%; the average of these larger declines is 30% or so, and the largest was 57% in 2009.
The entire regulatory system and most people in the industry do not address this volatility properly. The regulators cannot—or refuse to—distinguish between temporary price fluctuations and a loss. Most of the industry pretends that a questionnaire allows a salesperson ‘advisor’ to satisfactorily guess the investor’s ‘risk tolerance’. This is like a doctor giving you a prescription based on a questionnaire.
Investments with less volatility, such as GICs or bonds, generate over longer periods returns after inflation of 2% or so; today it is zero. The benefit of bonds is they decline very little, and very infrequently, so value is preserved over short time periods. Often people speak of stable prices as ‘safe’ investments, but you must see that stable prices, especially today, ensures the destruction of your purchasing power over time by inflation and taxes.
Only if you are willing to accept the volatility of equities can you be an equity investor. Most people are unaware that declines are normally as large as they are and that they cannot be avoided. So they become angry or fearful and destroy themselves in the process of trying to avoid the declines.
A portfolio can be constructed of bonds and stocks so that its volatility is anywhere on the spectrum between pure bonds and pure equities as discussed above. Only you, the investor, can tell me where on the spectrum you are comfortable. Understanding and deciding where on the spectrum you want to be can take hours of discussion; the decision is unique to each investor, and people frequently surprise me as to where they want to be, which is why a questionnaire, although it satisfies the pointy-headed legal people, is completely useless.
Then, and only then, can I recommend an investment strategy.
Have a conversation
People who recommend investments without having gone through this conversation—which is probably the vast majority of people in the investment industry—are being foolish because they ought to know better. My advice? For the remaining $40,000 that you need to invest, see a good advisor. You need to understand your risk tolerance and how this $40,000 fits into your financial profile. Only then can you get the most thoughtful answer on how to invest this money. It’s not one size fits all and the amount of money is substantial enough to have a thoughtful discussion with a good advisor who can help you assess your risk tolerance as well as your long-term goals.
— Chris Horan
Chris Horan is a Registered Financial Planner and senior financial advisor with Assante Capital Management Ltd., in Toronto.
More stories like this: