Risky Business: The Efficient Frontier

Risky Business: The Efficient Frontier

I was reading an article the other day about the risks associated with the COVID-19 vaccine. Don’t worry, this is not an article focused on vaccines and whether or not they work! This article simply had me thinking about risk and how everyone talks about risk differently. Some people use risk to balance pro’s and con’s. For example, jumping out of an airplane has pro’s and con’s. The “pro” is that it’s (probably) exhilarating. The “con” is that you could fall to your doom if your parachute doesn’t deploy.

I would say most people look at the above example and fall somewhere on the scale between wrapping yourself in bubble-wrap while staying away from the sun, and diving head first out of a plane WITHOUT a parachute. But what about specific investment situations?

I was chatting with someone recently who mentioned how the they chose bonds and GICs because they are “risk free”.

One of the more common comments we receive as advisors when discussing people’s investments, whether this is in a boardroom or on the golf course, goes something like this, “What kind of return do you guys get? My buddy, so-and-so, got 20% last year.” There’s nothing wrong with comparing returns if done in the context of risk. For example, how much risk did he have to take to get 20%? How has his investment performed in the years prior to last year? People love to talk about the good years. Oddly enough, some of that vigor leaves when they have to disclose the “down” years. So today, I want to chat about risk through the lens of financial planning. Maybe it will shed light on some areas of risk that are not always considered.

Investment risk

Risk comes in all shapes, sizes and perceptions. Risk perception is a key component, because it really aids in developing investor psychology. For example, some people view the S&P 500 (one of the main indexes for the US market) as a ‘risky’ investment. Others would argue the opposite. For the sake of illustration, I’ll argue both sides for you.

The S&P is a risky investment. It is made up entirely of stocks (ownership in different companies) and if those companies drop in value, so does the value of your portfolio. You leave the fate of your wealth in the hands of the men and women who run those companies AND other investors who will buy and sell those companies in bulk, which can sway the demand/supply relationship. In March of 2020, we saw a massive sell-off of stocks that equated to a roughly 30-35% decrease in the equity market. The sell-off was mainly based in fear of the economic forecast for companies, given that COVID-19 had finally made it’s way to North America.  Therefore, un-predictable elements can quickly shift the value of the S&P 500 and it is risky.

On the other hand, the S&P is not a risky investment. Some people look at the index and think, “historically, the S&P 500 has always produced a positive return given enough time.” When the market crashed in 2008, there was a massive sell-off of US stocks. Some investors were risk-adverse and moved their investment position to something less volatile (i.e bonds and GICs), but some benefited from a different perspective. They understood that the loss (or risk) only existed if they sold the investment, because given enough time, they would eventually recoup their losses and go on to even bigger gains. And that’s exactly what happened. It was a rough couple of years, but within a relatively short time the market had fully recovered and grew well beyond the values in 2008. The market, over the long-term, is predictable, and therefore is low risk.

There you have it. Both sides of the coin, or in most cases a 100-side dice. Everyone sees risk, and there isn’t one view that is 100% correct or wrong. Other factors have to be considered, such as time-horizon, investment purpose, and comfort.

So, why did my discussion on bonds make me think of writing a blog post about risk?

Out of all common investment vehicles, risk associated with bonds is highly misunderstood.

Disclosure: Many risks associated with bonds have to do with FOMO (Fear of Missing Out).

Take a government bond. Let’s say it’s a 4%/year bond that has a maturity (locked-in period) of 5 years. This bond would pay you 4% of simple interest every year for 5 years. On the 5th year, they would return your initial amount (called principle). This seems pretty low-risk right? It’s essentially an IOU to the government with an interest payment to compensate you for letting them borrow the money. Most people would go to the common sources of risk, i.e. what happens if the issuer (in this case, the government) goes under? Obviously, in a government bond, that is highly unlikely. But corporate bonds have some risk of bankruptcy. What about interest rate risk? This one’s interesting because it’s rarely talked about.

Say you have a 4% bond. Typically, these bonds are ‘non-cashable’ which means it’s harder to get your money out early if you need it. Let’s say your car breaks down in year 2. You may incur a penalty for getting your money back early, if you can get it back at all. The other option is to sell the bond to another investor. This is where we see interest rate risk.

What happens if you try to sell your 4% bond and the current rate for the same bond is 6%? Why would I (as a potential buyer) pay you full price for a 4% bond when I can go get an identical bond at 6%? This is where we start having to take a ‘loss’. If I can get a 6% bond when you’re selling a 4% bond, I would only buy yours if you’d sell it for a discount. Let’s say the principle of yours is $100,000. I may only pay you $98,113.20 for that bond, because at the end of the bond’s term, I will receive $100,000. That extra $1886.80 compensates me for the reduced interest payments along the way. This hurts you as the seller.

The reverse is also true. If the prevailing interest rate drops to 2%, you can sell your bond and make extra money because someone else wants to make 4%/year instead of 2%. That’s interest rate risk.

What about FOMO? There’s a term out there called the “Modern Portfolio Theory“. Before joining this industry, I had heard about it through movies but never really understood what it was. It was created by a man named Harry Markowitz in the 1950’s and theorized a way of lowering risk while maintaining return. A lot of his original ideas are used as rules of thumb in today’s environment because they have proven to be successful. He build the idea of the “Efficient Frontier“. I hope Star Trek fans don’t get too excited, because if they’re expecting another reboot, it’s not coming from Mr. Markowitz.

The Efficient Frontier essentially describes how to allocate your portfolio to reduce or maintain a certain level of risk while increasing return. From the image above, you can see that as return goes up, between ~6% and ~9%, the risk actually goes down. Hypothetically, a portfolio that returns 8%/year could have less risk than a portfolio that returns 6%. The “Efficient Frontier”, or most efficient portfolio, would then be something that returns ~10%.

These numbers have to be kept in context. The 1950’s supplied a very different market expectation than today, but I want to focus on the relationships between bonds and the Efficient Frontier. Most people look at bonds and consider them to be the lowest-risk option. Alternatively, by only being in bonds, you expose yourself to risk that is inherently linked to bond pricing (i.e. interest rates). Markowitz goes on in his theory to talk about how equity components can lower your overall risk by reducing bond-specific risk and trading it for equity-specific risk. The risk is not necessarily gone, but it has been diversified. In the same way we would diversify someone’s portfolio by geography or sector, we should also be diversifying by risk category. By only being in bonds, you potentially miss out (FOMO) on low risk returns in the equity (stock) market.

There are hundreds of different types of risk, but on contemplating the “Efficient Frontier”, I thought about how risk can be perceived. This article is not designed as an instruction to go and buy stock and add it to your portfolio, because from a holistic planning point of view, it may not be necessary. It is, however, designed to bring to light some previously unknown forms of risk that should be considered if you’re a fellow advisor or a DIYer. For all of the investors who have lived by the traditional theory of more bonds = less risk, I challenge you to “Boldly go where no man has gone before!” (Thanks Captain Kirk!).

Purchasing Power: The Effect Time Has on Your Money

Purchasing Power: The Effect Time Has on Your Money

The market is a scary place. If you decide to open up the Globe and Mail to check the daily news, you’ll find a stock market ‘ticker’ sitting smack-dab in the middle of the page. This is the equivalent to vending machines putting the most popular candy at eye level. Right now, with the current market situation, the tickers are often red, and from a psychological standpoint, red is a dangerous colour.

So in times of uncertainty like this, a common reaction is to revert to hiding your money under your mattress. Though it’s not a terrible idea to keep some cash on hand for emergencies, did you know that you are actually losing money by doing that?

Most people think they are protecting their wealth by putting it in a shoe box and leaving it alone, but in reality (and in market terms) that money is showing a negative return year after year. The principle is called the ‘Erosion of Purchasing Power’.

What is Purchasing Power?

Imagine your grandparents (or great grandparents) living through World War 1. 1917 was the highest inflation year in Canadian history at ~19%. What does that mean? The loaf of bread or jug of milk that cost $1 at the beginning of the year, cost $1.19 by Christmas. Inflation is the increased (or decreased) cost of goods and services over a period of time (usually a year).

1917 was an anomaly. We had just come out of the World War, the global economic landscape was changing, and a lot of policies were born out of that period of time. More recently, the government has strictly tried to maintain an inflation rate of ~2%/year.

Now, lets go back to the shoe box full of cash in the closet. Let’s assume that there is $10,000 in the box and it was put aside in 1970 as a way to start saving for retirement. Back in the 70’s, you could buy a house in Toronto for ~$30,000, so $10,000 was a substantial amount of money. The yearly income in Canada in the 70’s was averaging between $5,500 and $7,000/year (based on minimum wage being $2.60/hr).

First off, having $10,000 to put in a shoe box for retirement in the 70’s was a big deal. That was almost 2 years worth of salary. At the time, you could buy 1/3 of a home in Toronto, live without going to work for almost 2 years, or achieve a vast number of other objectives usually reserved for the top 1%.

But the box is in your closet collecting dust. Inflation is slowly raising the price of goods and services around you and you forget about the cash. Fast forward to 2020. You are ready to retire. You suddenly remember you stashed this great wealth in your closet and you go to collect it. Sadly, you see just $10,000 in a box.

The loaf of bread that cost $1 now costs $4. The land alone where you could have bought the $30,000 house is worth $800,000+.

Your $10,000 will afford you a nice vacation, but doesn’t come close to the basic income needed for a family to survive. The power that you had to purchase goods with that $10,000 has declined dramatically over the 50 years that it sat in a box.

How do you avoid inflation?

Short answer is that you can’t. Inflation is a result of a variety of factors including currency value, debt load, import/export ratios, interest rates, and taxation. The good news is that it can be counteracted. The new equivalent to a box in the closet is GIC’s (Guaranteed Interest Certificate). They are the ultra-low risk investment that will help your money keep pace with inflation.

But do you want all of your money to keep pace with inflation, or would you rather take some risk and have the land worth $800,000?

The Three Bucket Approach

This is some free advice, and I use this template with a lot of clients because it quenches many of their hesitations and concerns.

Imagine you have 3 buckets, and all of your savings will be in one of those 3 buckets. The first bucket is your bank account or cash in the shoe box. Its purpose is to provide a source of cash that can be accessed quickly in case of emergency. If you need to book a quick flight or get a repair on a car, this is where you turn to first.

Side Note: Many people accept credit cards as their “quick access” solution, but that more often leads to major debt problems.

The second bucket is your short term goals. The goals themselves are dependent on you as an individual, but the idea is to provide quick access (liquidity) while obtaining some growth for the future. often this bucket contains a portion of their emergency fund. It allows your emergency fund to reflect the changes brought on by inflation.

The third bucket is your long term goals. For some people, there would be very little change in how your long term and short term goals are invested, but generically, you can afford to accept more risk when you have a longer period of time. Higher risk should result in higher returns.

This approach is a foundational piece to people’s investment strategy, and a key deterrent to the erosion of purchasing power. For perspective, if the $10,000 from our shoe box simply kept pace with inflation (a non-adventurous goal), it would be worth ~$68,162.86. Back in 1970, $10,000 gave you options. In 2020, $10,000 doesn’t reach as far or present the same opportunity.

Now if we translate the conversation towards the future, what kind of freedom would you have if you let your money’s purchasing power erode? Are you helping your ‘future self’ accomplish their goals? Planning for the future is more than putting money into a box. It’s asking yourself: how will this money impact my family’s quality of life down the road? Do you want to see the opportunities diminish with time, or know that when the time comes, you’ll have to tools available to take advantage of whatever comes your way?

The Novice Investor: Piecing Together Your Investment Vehicle

The Novice Investor: Piecing Together Your Investment Vehicle

Investing… Stocks… Bonds… Mutual Funds… Markets… Internal Rates of Return… Value versus Growth Investing… ESG Investing… Portfolios… ETFs… Savings Rates… Risk Profiles…

There is so much out there when it comes to the parts and principles of investing that it can be hard to digest. On one hand, we are told to invest, and on the other, we are told to not do anything without knowing what we’re doing. That ideology can force a rift in people’s planning and cause them to be idle. I have had clients who sit on tens of thousands of dollars in their bank account, and most often the reason is that they don’t understand their options.

The richest men in the world have built their fortunes by having multiple streams of income. Jeff Bezos, the founder and owner of Amazon, is currently the richest man on earth. If we looked at his income strategy, you would see multiple inflows. First, he has his salary from Amazon. Secondly, he has his Amazon shares that increase in value as the company grows. Third, I imagine we would find that he has money tucked away into shares of other companies, which are also growing. All of these sources accumulate to roughly $2500 per second in income (from “The Registered Citizen”).

Especially with the current ongoing crisis, there are lots of headlines that say you should stay away from the world markets. Oddly enough, you can often find a link nearby that will tell you how to setup a ‘side-gig’ from home to earn more money. Each person has a unique situation, and in this post, I would like to explore how you can design your own secondary income streams. I will be using the analogy of a car, as it makes it easier to conceptualize investment components.

First, I would like to define the difference between ‘Active’ and ‘Passive’ income. It’s pretty self-explanatory, but active income (also known as “earned income”) refers to income you have to physically make. This would include going out to a job and getting paid a wage/salary. Passive income on the other hand is income gained for you by others. Investing falls into the category of passive income.

For the purpose of simplicity, I will speak in terms of mutual funds (which I will define later). Investing can be broken down into two parts: Equity and Fixed Income.

Equity:

Equities, also known as stocks, are the engine of our car. To have ‘equity’ in something is to own it. For example, Jeff Bezos has equity in Amazon because he owns shares (or stock) in the company. As the company increases in value, the market price of your shares increases. This means that every time you purchase something on Amazon, not only does Amazon’s revenue increase (which increases Jeff Bezos’s salary or bonus), it also increases the value of the company, therefore increasing the price of each share.

It doesn’t necessarily have to be companies. There are some investments that hold their equity in other areas, such as gold. In this case, the fund manager will buy gold, and sell ‘shares’ of the gold on the open market. As the value of gold increases, the value of each share also increases and people can sell their shares for a profit. 

Equities can define how fast and how long your car will run. Within equities, you can dive into asset qualities and other specifics that can be as different as the electric engine is to a V8 supercharged sports car’s engine. Equities give us the power and growth potential we need to earn our passive income.

Fixed Income:

Fixed income (also known as ‘bonds’) are the safety features of the car and this form of investment is far simpler than equities. In every sense of the phrase, it is an “IOU”. You, as the investor, are lending money to governments or companies for them to use in their operations. This is a lower risk and lower reward strategy for investing. The company or government gets a loan, and you receive a regular interest payment. For example, if you were to lend Amazon $10,000, they would pay you an interest payment (i.e. 1.5% or $150) either annually or divided monthly and return the $10,000 balance at the end of the term.

One common factor you’ll often hear about bonds is related to the interest rate.

If we paused time and looked at interest rates now, we would see a sharp decline in a new bond compared to 1 year ago. This is because the Bank of Canada (along with other country’s banks) have dropped interest rates in an attempt to stimulate the economy. Interest rates play a large role in the ‘risk’ associated with a bond, but that analysis is for another post.

Traditionally, bonds are a much safer way to invest, as there is little risk of a government or company not honouring and paying that debt back, but it also carries a lower reward. Your $10,000 does not participate in company growth in the same way equities do.

In regards to it’s relationship to our car analogy, with fixed income being the safety system, bonds protect the car as it moves. If there was an event that was cause for concern (for example, the markets dropped in value and you were unable to go to work), the fixed income component would preserve a portion of the investment to limit the damage.

The whole purpose and the relationship between equities and fixed income is to get you from Point A (where you are now financially) to Point B (retirement, first house, education, etc.). This is where mutual funds come into play.

Mutual Funds:

What are mutual funds?

Again, by their name, it is easy to guess that they are a funds designed to be invested by multiple people pooling their money toward a mutual goal. There are lots of different types of mutual funds. For example, there are funds designed for people who want to invest in certain parts of the world, different industries, or even subject to certain moral or ethical standards.

At it’s core, a mutual fund is a makeup of equities and/or bonds that provide growth opportunity while minimizing the downside potential. Since everyone’s risk tolerance and time horizon is different, finding the right mutual fund (or funds) to invest in takes more thought than most people would imagine. If you are considered ‘high-risk’ you may want a mutual fund that holds more equities than bonds. Vice versa, if you were closer to retirement and wanted to preserve your investment, you would lean toward a higher allocation of fixed income and safety.

Common Question: How is this better than buying individual stocks?

Quick answer: it depends. Do you have the time?

A long time advisor once shared an analogy with me that I thought was powerful. Unfortunately, it is highly visual, but I will do my best to paint the scene.

Diversification is one of the main strategies used by mutual funds. Imagine you have a pencil, and that pencil represents a stock. It can be any stock you’d like, but it is one single stock. You have heard that this company has a strong future and will grow in value for you, so you ‘get in at the ground floor’, and invest everything into that company. Now, fast forward in time. We have an event such as the recession of 2008, the tech bubble of 2000, or the current COVID-19 crisis. That company is put under financial stress, as this is an unforeseen position and the world is rapidly changing. Some companies are able to adapt and survive, and others can’t change fast enough and are forced to shut down. A real example of this may be the loss of mega-companies such as Sears. Sears couldn’t adapt to cater to the online shopper and subsequently ‘died out’. Any stock that Sears had is worthless today.

bunch of pencilsSo… take your imaginary pencil and bend it. Imagine that you bending the pencil is the company going through a stressful period. Does it snap? Maybe not, but you, as the share holder, are not protected from the companies failure. The money you invested could be gone.

Now imagine you have a box of 50 pencils, each pencil still representing a single stock. You take them out of the box, you strap an elastic band around them, and you try to bend them all together.

They don’t break so easily.

The difference between trying to buy individual stocks and buying a mutual fund, is that the mutual fund offers greater diversity and protection from market fluctuation. Theoretically, you could go out and buy 50 individual stocks and manually create your own diversification, but most people would find it takes a lot of work to purchase, research, value, sell, re-balance and execute a specific investment strategy while also earning income at their own career. The mutual fund offers a much simpler solution to investors and can create a stream of passive income.

Summary:

The value of not putting all of your eggs in one basket is that you are more protected from a depressed market. A crazy and unexpected event occurs and some of the companies feel the stress, but even if one company falls to the wayside, your portfolio is held together by the remaining mix of equities and fixed income.

Creating passive income can be more than working a 9-to-5 career and investing in mutual funds, but investments are a staple in most successful people’s financial structure.

I want to circle back to my original analogy.

A car has a single purpose. The kind of car, how fast you drive, and where you are going is up to you. But at the end of the day, the car’s role is to transport you from where you are now to where you want to be in the future. If you start your journey without enough gas in the tank or with worn out tires, you are putting yourself at risk of stalling or having problems down the road. Like an investment strategy, a car with proper care and maintenance will ensure you eventually reach your goal.

Proper investment strategies can provide peace of mind when traveling down life’s roads. You never know when there will be an unexpected twist or turn, and being prepared is a key to success.