Will I have enough money to retire comfortably? More and more, people nearing retirement have to confront this question. Risks to wealth are many—inflation erosion, fluctuating interest rates, and taxes—to name a few. However, these risks can be anticipated, assessed, and managed.
Overall, managing risk depends on your ability to define a long-term investment strategy. This includes identifying investment goals, the level of portfolio volatility that you are comfortable with, your time horizon, and appropriate asset allocation. Your ability to keep to this strategy in the face of market shifts is important. You may also want to consider working with a qualified financial expert.
Since most people equate risk to what the market might do to an investment portfolio, let’s explore some of the top investment risks, as well as strategies to manage them.
How can I manage market risk?
It is prudent to always keep in mind that the markets can pose a risk to your portfolio. For example, if you have $100 in your portfolio and the market drops by 20%, you now have $80. The portfolio would need to gain 25% to return to its original value of $100. In addition, if you withdrew money from the account at the same time, the portfolio would have a more difficult time recovering. To understand market risk, it is essential to understand just how volatile a portfolio might be. With that in mind, the following concepts will help you better understand, and manage, market risk.
Standard deviation: Volatility can be measured using standard deviation—the investment’s performance above or below the average return over a period of time. The higher the return that an investor needs or wants, the more volatile the portfolio is likely to be. As such, a volatile stock will have a higher standard deviation. Moreover, a higher volatility portfolio means the potential for higher returns, but with higher risk.
Time frame: Equities are best over the long term compared to fixed income; the length of time in the market, not timing, is what helps brings success. When investors set long-term financial goals, with the appropriate asset allocation, they are more likely to reach their goals. Investors are better off not changing their long-term approach based on short-term market movements.
Asset allocation: Over the long term, asset allocation is one of the most important contributors to a portfolio’s success. A portfolio that contains a certain percentage of equities, bonds, and cash may achieve a higher rate of return for the risk compared to another portfolio, since the combination of assets will produce differing patterns of risk and return. The “efficient frontier” is a resource that can help determine asset allocation and its associated risk level. It charts the potential return that investors might expect based on the volatility they experience.
Portfolio rebalancing: You should periodically rebalance the weightings of each asset class in your portfolios. Some investments may outperform others and, as a result, take on a greater share of the total. If the portfolio is not rebalanced, it may drift away from the long-term asset mix originally targeted. As a result, you could be taking on more risk than originally anticipated.
How can inflation risk and interest rate risk affect my investments?
Over the years, even low inflation reveals itself. At the historical average of 3%, a $1,000 expense today will cost more than twice that in 25 years. This kind of inflation may cause anyone living on a fixed income to feel the loss of purchasing power more keenly. This is especially apparent with non-discretionary items such as food, household goods and property taxes (if applicable).
Interest rate risk also poses a challenge. If you anticipated funding your retirement on once-attractive rates, you will likely have witnessed a significant decrease in these rates.
To address inflation and interest rate risks, financial strategies—like diversification—can help your money work harder and smarter.
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Do investment fees pose a risk? And are investment fees tax deductible?
Good investment advice can produce returns that outweigh fees paid to a financial advisor. The fees that you pay for expert advice should be transparent, and you should be able to talk to your advisor about them. Make sure you are not locked into your investments and that there are no penalties to get out.
The fees you pay are outlined in your investment statements. You can also request annual management fee summaries from your portfolio manager. This will ensure transparency and provide tax efficiency, as most fees from non-registered accounts are tax deductible (excluding commissions).
How can health and long-term care risk impact investments?
Retirees should consider, and plan for, the costs of medical and long-term care. For example, do you want to access private care or subsidized care? Thanks to medical advances, we are living longer. With this longevity comes an increased financial risk that should be addressed through financial strategies such as savings, income structuring or tax management.
As a retiree, you should also be aware that you might outlive your money. For example, to determine the amount and duration of the payments that a client will receive in retirement, some registered retirement savings plans use age projections that anticipate clients will live to eighty-two years old – but today, most people are expected to live longer. To address this situation, age projections should be set to at least age ninety.
Human nature and investing: What’s the risk?
One of the greatest risks that we face is ourselves. As investors, we can fall victim to our own biases and fears. For example, one may panic and sell their investments during a market downturn, potentially generating lower returns or even losses.
Much of the value that a financial advisor can add to a client’s returns comes from the advisor’s role as a “behavioural coach”. They can help keep clients focused on the long term, by steering them away from the temptation to time the market and chase returns, by keeping them faithful to a regular investment plan.
Above all, navigating investment risks through successful financial planning requires self-awareness: What are you hoping to accomplish? What are your motivations? Are you able to establish and commit to an investment plan?
Did you know that you can book a free financial literacy presentation for your workplace or community group through CPA Canada? Sessions can be targeted towards different audiences (i.e. post-secondary students, entrepreneurs, seniors, New Canadians, etc.), and our presenters can come to you.
Bryan Sommer, CPA, CA, CFP, CIM, is a portfolio manager with CIBC Wood Gundy and holds the Chartered Professional Accountant designation. This article is based on “Weighing the Risks,” a chapter from his book, The Reveal: Stepping across the Line into Retirement.
1 http://www.bankofcanada.ca/rates/related/inflation-calculator/
2 https://www.bankofcanada.ca/wp-content/uploads/2010/09/selected_historical_v122530.pdf
