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Gauging risk needs
Don't take more risk than necessary

Last week, I explored why the roller-coaster ride known as the stock market had made investors lose their appetite for stocks in recent months. However, that discussion is incomplete without addressing the reality that investors remain confused about how to gauge risk and how the determine how much risk they need to assume.

Risk definitions

As noted last week, risk means different things to different people - there is no standard definition. I'd go so far as say that risk has a customized definition for each of us.

For instance, many retirees simply want to ensure that they live longer than their investments so that they never see the day that their portfolio goes down to zero. Some simply want to die broke so that every last penny is enjoyed. Yet others want to minimize the up and down fluctuations in value. Finally, more aggressive investors will often get attached to a specific target rate of return, like ten per cent annually.

In conjunction with outlining what you want your money to do for you (i.e. defining your objective), think about what risk means to you - rather than to your neighbours or to the media.

The risk premium

Sally is a 65-year-old retired widow with a portfolio worth $500,000. She needs to take $30,000 each year to cover her lifestyle expenses (including taxes) - a figure that will need to rise as her lifestyle costs rise. She wants to plan for at least thirty years since her family history is filled with longevity. How much risk must Sally take to achieve her goal?

Upon first glance, it might appear as if Sally would be fine with guaranteed investment certificates (GICs), but that's not the case. Sure, the initial amount she needs only adds up to 6% of her total current portfolio value. However, GICs will only allow her to increase her cash flow if interest rates rise - and then only if she can roll over her GIC at sufficiently higher rates.

Currently, five-year GIC rates are hovering around the 4 per cent mark. If she locked in that rate for the next five years, Sally would need a guaranteed rate of 7.5 per cent in each of the next twenty-five years to ensure that her portfolio runs out of money at the end of the thirtieth year.

Posted five-year GIC rates have averaged just south of 7 per cent annually over the past fifteen years. Hence, securing 7.5 per cent for twenty-five years is not realistic - particularly when you consider that persistently high inflation would be needed to sustain interest rates at that level for such a long time.

Sally will now be left with a decision: How much of her portfolio must she expose to risk (i.e. stock, bonds, and other non-guaranteed investments) for her to achieve her desired level of consistent cash flow?

Since she will be introducing some level of risk into her portfolio, Sally will also need a higher rate of return to compensate for that risk (i.e. a risk premium). I figure Sally will need to generate an average annual compound rate of return of about 8 annually. That figure comes from the initial withdrawal amount as a percentage of her current value, 6 per cent ($20k / $500k), plus an estimated 2 per cent annualized inflation protection.

It's a rough estimate, but it's close to what would be required. Based on a return requirement of 8 per cent annually, Sally will need a diversified mix of stocks, bonds (i.e. domestic, foreign, real return), cash, and hard assets (i.e. natural resources, precious metals, and real estate). How much of each component she decides upon depends not only on her return requirement, but also on her personal comfort level.

In summary, Sally can't meet her objectives simply by investing entirely in guaranteed vehicles. She must introduce some investments into her portfolio that don't carry guarantees but that offer the potential of higher returns. Higher returns are needed to make the extra risk worthwhile. That extra return is known as a risk premium.

(For a refresher on the factors affecting the sustainability of regular portfolio withdrawals, take a peek at this recent article)

Final thought

It doesn't make a whole lot of sense for investors like Sally to take more risk than is needed. If a GIC will comfortably meet your goals, then go for it. It's boring, but if it gets the job done, there's no need to get fancy.

However, most investors don't have the luxury of being able to achieve their investment goals with plain old GICs. This is particularly true of investors that have specific estate plans that involve leaving money to heirs. In such a case, both the needs of the current investor and those of the future heirs need to be taken into consideration in structuring the portfolio.

Deciding on specific investment strategies is a very individual decision. Clearly defining your rate of return needs will help in deciding how much risk is needed.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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