By Mike Fortunato, CIM®, FCSI®

image:FHM.com - Warner Bros.

 

This is the fifth and final instalment in our five-part series about risk. In the previous instalments we introduced three types of risk that investors need to consider when trying to achieve an investment goal: Volatility Risk, Shortfall Risk and Absolute Risk. We then took a deeper look at each type of risk and discussed ways to manage them. In this last instalment I want to illuminate the relationship among these three risks and suggest some strategies that exploit these connections to lower overall risk and help us reach our goals.

Let’s quickly summarize each risk, and my recap my tips for managing them:

Volatility Risk refers to the potential fluctuations in value an investment may experience while owned. It doesn’t represent a realized loss (or gain) unless that investment is sold. Generally speaking, the investments that have historically provided the highest potential return also tend to have higher volatility, whereas the investments with the lowest volatility have tended to have the lowest return. I believe that Volatility Risk is best managed by ensuring your portfolio’s volatility is appropriate for your time horizon. Investors with longer time horizons are in a better position to accept more Volatility Risk, because there is adequate time for their portfolio to recover from a “paper-loss”. Conversely, if an investor has a shorter time horizon, then they should opt to hold investments that are less volatile. By properly constructing a portfolio that complements their time horizon, investors create a situation where they are insulated from the negative effects of volatility. The benefit of managing Volatility Risk with an appropriate time horizon is that investors don’t have to limit security selection to low volatility choices investments that come with lower return; investors, however, do need to be mindful that unplanned emergency withdrawals will reintroduce the effects of Volatility Risk back into the equation.

Shortfall Risk is the potential of not reaching an investment goal because the actual rate of return received was less than the expected rate of return. Beyond achieving a satisfactory rate of return, which goes without saying, there are two things investors should focus on that will help minimize shortfall risk:

1. Striving to contribute more money towards the goal, as frequently as possible.
2. Making sure their goal is realistic given their time horizon and situational constraints.

Like Volatility Risk, the best ways to combat Shortfall Risk come from behaviours that go beyond security selection and instead focus on the larger picture of the investors goal and plan to achieve it.

Absolute Risk is the risk of experiencing some sort of personal catastrophe or emergency. It is unlike the above two risks because it is only indirectly related to the investor’s goal; however, it has the ability to derail an investment plan because it may force an investor to stop saving, or worse, withdraw from their plan. The best way to combat this risk is to put yourself in a situation where it won’t affect your investment plan. This can be accomplished by insulating your investments from a personal emergency by having both an emergency fund and adequate insurance.

As you can see these three risks are huge obstacles that investors must navigate if they are going to reach their goals. Although these risks impact different aspects of an investor’s plan, they are connected in ways which can be exploited. One common thread these risks all share is that they can all largely be managed through how an investment plan is structured in relation to the goal it is trying to achieve.
Prioritizing these three risks is the key to combating them. Even though Shortfall Risk is the most important of the three risks I tend to make it my last priority because it can be largely solved by first controlling the other two risks. As we saw above, beyond achieving a satisfactory rate of return, two habits that minimize Shortfall Risk are: 

1. Striving to contribute more money towards the goal, as frequently as possible.
2. Making sure the goal is realistic given the time horizon and situational constraints.

Both of these items are staples of a solid financial plan; however, the first habit can be disrupted if an Absolute Risk materializes. More specifically, investors might be compelled to tap their investments for funds in the event of a personal emergency. Viewed in this way, Absolute Risks are actually a potential cause of Shortfall Risks. By having an emergency fund and adequate insurance investors not only mitigate the effects of Absolute Risks, but also help indirectly minimize Shortfall Risks.

The second habit that helps minimize Shortfall Risks is making sure that investors’ goals are realistic given their time horizon and situational constraints. As you may recall, however, the exercise of taking a broad view of an investment plan in the context an end goal is an indispensable tool that investors can use to insulate themselves from Volatility Risks. My view has always been that rather than run from volatility, investors should first see if they can create a financial plan that can embrace volatility and the return that can be correlated with it. The only caveat of this approach is that investors need to ensure that they can adhere to their time horizon and not be compelled to alter their investment plan to cover a temporary life emergency with investment funds. But we already addressed this earlier by first focusing on Absolute Risk, through having an emergency fund and insurance.

Below I’ve created a flow-chart to help illustrate how I mentally prioritize these risks. This chart isn’t the only solution to the problem of managing these risks, it just happens to be a structure that has worked well for the financial plans I’ve help create. Starting at the top the chart flows towards the risk that represents ultimate failure: Shortfall Risk. However, you will notice that Shortfall Risk is the last step in the flow-chart because it is largely combated by first solving the other elements in the chart.

In conclusion, I believe that Volatility Risk, Shortfall Risk & Absolute Risk are the three most important risks that stand in the way of investors reaching their goals. Individually these risks have the potential to hurt an investment plan, but also, when mismanaged, their negative effects can be compounded. By prioritizing these three risks investors can leverage how these risks are interconnected and focus on only a few crucial habits to combat their negative effects. Instead of juggling three risks investors can instead view this as a single exercise in creating a solid financial plan that complements their financial goal. These risks will still exist; however, a solid plan will help investors steer clear of those risks while constantly keeping them in view.

 

 

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros.

 

In the last two instalments in this article about risk we took a closer look at Volatility Risk & Shortfall Risk. Today I’m going to breakdown my thoughts on Absolute Risk.

Absolute Risk

When I refer to Absolute Risk I’m talking about the type of risk that is often associated with insurance. Absolute risk is any risk where there is no possibility of gain; there is only the risk of loss. Examples would include events like: health issues, losing a job, or any sudden, unplanned expense. Although Absolute Risk doesn’t affect an investor’s portfolio directly; it does damage an investor’s overall financial position, and usually impacts their investing behaviours.

I’ve witnessed many investors drastically alter their investment plan after experiencing an unexpected loss. For example, after losing a job, many investors frequently stop contributing to their retirement accounts, and some investors even go so far as to withdrawal from their RRSP triggering withholding taxes and other penalties. As we saw in the last instalment, one of the most important variables in reaching a financial goal is saving regularly; and this is where Absolute Risks can do the most damage. Your money can’t grow if it is not invested, so during an emergency, time spent on the sidelines that isn’t automatically contributing towards your goal will equate to more time needed to reach your goals. Also, withdrawing a sizeable portion of your goal to cover an emergency can be even more devastating because not only are you not contributing, but now there is less left in the pot to grow.

There is one more hidden risk that can result from an Absolute Risk materializing. An Absolute Risk can expose you to unplanned Volatility Risk. As I mentioned in the second instalment of this article: when properly managed, Volatility Risk is only a threat when investors are forced to sell their investments at an unplanned time. When such an emergency occurs, it might force a sale at a price lower than what they expected. This will exacerbate the negative effects towards their investment goal because they’re forced to sell more shares than expected, which adds more time to their recovery. Although this may seem like an unlikely doomsday scenario, it is actually a reality for many investors, as most employers are forced to lay off employees when the economy is doing poorly, which also tends to be when the investment markets are performing poorly.

Many investors have a poor plan, or worse, no plan to manage Absolute Risks. In fact, most of the investors I’ve encountered view their investment accounts as quasi-emergency funds: their only alternate source of savings in the event of an emergency. This is the reason why Absolute Risk can really wreak havoc to an investor’s investment goals. The best way to manage Absolute Risks is by having both an emergency fund and having adequate insurance. The only way to ensure that an emergency will have no impact on your investments is to completely insulate your investments from that risk. I always encourage investors to compartmentalize their investment accounts, and mentally forget about them as a potential source of emergency cash, but this is easier said than done when a real emergency strikes. That is why investors should have an emergency fund and proper insurance before they start investing. I could write a whole article about how much emergency cash and insurance someone should keep on the sidelines, but a good rule of thumb would be to make sure the amount saved will realistically cover the cost of an actual emergency.

Absolute Risk was the third and final risk I wanted to discuss in this series. Although they don’t directly impact your portfolio, they can hurt your financial goals indirectly. In the next, and final instalment of this article I will discuss how all three of these risks are interrelated, and a strategy that investors can use to manage all three.

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros.

 

In the first instalment of this article we introduced three types of risk: Volatility, Shortfall and Absolute. In the last instalment we took a closer a Volatility Risk. Today I’d like to examine Shortfall Risk and give you my perspective on how to best manage it.

Shortfall Risk

As you may recall, Shortfall Risk is the risk that an investment’s actual return will be less than the expected return needed to meet a financial obligation. Another way to think about shortfall risk is to say that it is the risk of falling short of an investment target or goal. To me, this is the most important risk because when it occurs it means you’ve failed to achieve your goal in your desired time frame. Oddly though, many investors don’t start seriously focusing on this risk until it is too late.

When it comes to shortfall risk I also think many investors are focusing too much on the variable that is the hardest to control: obtaining a high rate of return. Once a reasonable rate of return is achieved it becomes increasingly harder to put in more research and get more out in terms of added return. The law of diminishing returns seems to also apply to investment returns. Sure, with proper due diligence and adherence to sound portfolio management best practices it is possible to obtain a strong long-term rate of return, but far too many investors are banking on achieving double-digit returns to reach their long-term goals. I’m not saying that is impossible to achieve consistent double-digit returns, but it simply isn’t a realistic expectation for most investors.

Many investors would be better served if they focused less on rate of return and instead focused more on the other variables that they have more control over:

• The amount they contribute towards their goal.
• How frequently they contribute to their goal.
• How reasonable their goal is in relation to their time horizon.

Just to be clear, I’m not saying that striving for a high rate of return isn’t important, in fact, the previous instalment of this article talked about how I feel that under the right conditions, rate of return is more important than Volatility Risk; what I am trying to say is that investors need to understand what will impact their financial goal the most.

Here is an example to illustrate how important saving is in relation to rate of return. Let’s compare two different investors: Ray & Warren who both invest for a 20-year period. Ray earns a higher rate of return than Warren: 8% per year, but he saves less on an annual basis: only $600 per year. Warren, on the other hand, earns a lower rate of return at only 6% per year, but happens to saves more on an annual basis: $800 per year. Let’s see whose portfolio grows more after 20 years.

As you can see, even though Warren is earning a lower rate of return, he still comes out ahead because he was saving more each year. Also, we only used 6% as our forecast for Warren, which has a higher chance of materializing in real life instead of the 8% used for Ray. Certainly, it is possible to obtain a long-term return that is higher than 6%, but it is always helpful to be conservative in your estimates.

The other variable that investors have control over is how realistic their goal is in relation to their time horizon. I’m not going to suggest a specific formula to generate a realistic goal, because that would be an entire topic on its own, but I will highlight some general principles that are important to consider. The shorter your time horizon, the lower expected return you should use in your forecast. The reason for this is because you will want to limit your exposure to Volatility Risk if you don’t have the time to ride out the bumpy ups & downs of the market, and as I mentioned in the previous article, generally speaking, there are some trades-offs in return that come with less volatile investments. Yes, there are advanced portfolio building techniques you can employ to try to maximize your growth while keeping your volatility in check, but as we saw in the above example a few extra percent of growth each year is less important than trying to find ways to save more towards your end goal – especially with shorter time horizons. Also, extra return will help a lot over longer time horizons, but as we learned in the previous instalment of this article, exposure to volatility risk becomes less important when your time horizon is shorter.

In summary, Shortfall risk is one of the most important risks investors face because it is literally the risk of failing to achieve their goal. The best way to minimize Shortfall is to first ensure your goal is realistic in terms of the rate of return you need to assume to reach the goal within your time horizon. Then do everything you can to maximize how much you save and contribute to your goal over time. These are the variables you have the most control over. In the next instalment of this article we’ll examine the third and last type of risk: Absolute Risk.

By Mike Fortunato, CIM®, FCSI®

image:FHM.com - Warner Bros. 

In the first part of this article I introduced three types of risk: Volatility, Shortfall and Absolute. Today I’d like to continue from where we left off. There are literally dozens of other categories and subcategories of investment risk, but I’m going to restrict our discussion to just these three because many of the other risks I have not mentioned are actually related. Now that we’ve limited our discussion to just these three, I’d like to describe my observations regarding how many investors view and consider these risks, and I’ll offer an alternative point of view for consideration.

Volatility Risk

As I already mentioned, volatility risk is expressed by an investment’s standard deviation. It is a measure of how the price of an investment fluctuates over time. There are however, a few important aspects of this type of risk that I think are very important to mention: 


• When we measure an asset’s standard deviation, we are measuring past fluctuations in price.
• An investment’s historical volatility can give us some insights into how it will behave in the future, but there is no guarantee that an investment’s future volatility will be the same as its historical volatility.
• Standard deviation measures absolute changes in price and treats rising prices and falling prices the same, but investors are usually more concerned about the negative consequences of falling prices verses the positive consequences of an investment rising in value.

There is one aspect to volatility that I think is most important: when an investment’s market price falls in value it doesn’t necessarily mean you’ve lost any money, just like when an investment’s market price rises you haven’t necessarily gained any money. In order for an investor to realize an investment’s loss or a gain, they first need to sell their investment, and until they do sell we refer to their position as having a “paper-loss” or “paper-gain”. Volatility, as you recall, only measures the magnitude of an investment’s market price fluctuations. So simply holding a volatile investment has no real bearing on what your future loss or gain might be. In our illustration above, both ABC & XYZ ended at the same value: had both of them been sold on January 31st, the return for the investor would have been the same. Volatility, in this example, actually had no bearing on the rate of return. Volatility could have potentially affected the results if the investor had to sell either investment at some time between January 1st and January 31st. If for example, we had to sell on January 10th, XYZ would have experienced a greater loss than ABC.

 

In the scenarios I just described volatility only really matters in a situation when investors are compelled to sell their investment early during the chart. I’m not saying that all volatile investments eventually move towards a paper-gain, but what I am trying to highlight is that under certain conditions & assumptions other factors matter much more than volatility. Those other conditions & assumptions are:


• Your time horizon should complement your portfolio’s volatility.
• Your investments need to have a reasonable long-term rate of return.
• You are not compelled, for whatever reason, to prematurely sell your investments before your stated time horizon.


You might be thinking, why not just find an investment that has no volatility (basically just a straight diagonal line on the chart)? Those types of investments do exist; however, history has shown that there is somewhat of a trade-off between return and volatility. A GIC would be an example of an investment with basically zero volatility, but your real return (after-tax, inflation-adjusted) would be close to zero as well. Generally speaking, the market considers volatility when pricing assets, and assets that tend to be more volatility are typically valued in a manner that compensates investors for taking on the excess volatility risk. The end result is that, generally speaking, the assets that carry the most volatility also tend to carry the highest chance for long-term return. Investors who are cognizant of these facts can exploit them to their benefit by opting to hold the investments that provide a volatility discount while ensuring that their holding period insulates them from the potential negative effects of Volatility Risk.

Although understanding an investment’s potential volatility is important, I think some investors are paying too much attention to it for the wrong reasons. Many investors are conflating volatility with only losing money, and forgetting that the most volatile asset class: equities, tends to have the highest long-term returns. I can understand why investors are worried, as we all recall past high profile stocks that have gone bust, but that type of risk can be mitigated through proper diversification and fundamental due diligence. In my opinion, investors would be better served by trying to make their portfolio’s volatility complement their investment time horizon. Although it is logical to invest in the assets that will provide the best return over your time horizon, and ignore volatility that won’t affect their goal, many investors still find it challenging to watch the “paper-value” of their portfolios temporarily lose value. This often causes investors to alter the optimal composition of their portfolios in favour of an allocation that will provide less long-term return but with less overall volatility. Being overly conservative, however, is still better than the two other likely alternatives: overreacting and selling during a market drawdown, and, not investing at all.

I’ll end this instalment with one final note: Above, I presented a general concept about how I believe investors can maximize returns by ignoring volatility that doesn’t affect their long-term return. The tricky part is selecting investments that will provide that long-term return. I’m not suggesting that volatility causes investments to have high returns, but rather, I’m saying that often the investments with the best return might also have higher volatility. The goal of the investor should be finding the investments that will perform the best in their portfolio, regardless of the volatility of those investments: as long as they can tolerate the ups and downs without overreacting, and are not dependant on the portfolio for income or emergency cash.

In the next instalment I’ll take a closer look at Shortfall Risk, and hopefully illuminate some ways it can be managed.

By Mike Fortunato, CIM®, FCSI®

 

image:FHM.com - Warner Bros. 

 

What is risk? What does it mean for something to be risky? Well, the dictionary defines “risk” as: “a situation involving exposure to danger”, and defines “danger” as: ‘the possibility of suffering from harm’. Okay, so risk seems to involve two parts: the element of a negative future consequence, as well as a probabilistic element. But I didn’t need to look up “risk” in the dictionary. After all, everyone intuitively grasps the concept of risk. We all experience risk in our day to day lives. There are physical risks like: driving in a car, walking across the street or riding on a plane or boat, but there are also risks that don’t involve physical harm like: switching careers, starting a new relationship, or gambling. All these examples are considered risky even though the consequences and probabilities are quite different. Clearly, risk can take on many forms. As a portfolio manager and advisor, I’m most concerned with how risk impacts wealth creation and the investments of my clients who have entrusted me with their financial future. 

We’ve all heard the phrase: “investing involves risk”, but just like everyday life, risk, as it pertains to wealth management and investing, can take on many different forms. If you ask several people to define “risk”, in the context of investing, you’ll likely receive a diverse set of responses. You’re also bound to hear contrasting opinions as to how to best combat or control those same risks. In this article I plan to illuminate the concept of “risk” and offer some advice on how it can be managed. To tackle this topic, I’ll first need to thoroughly define what I mean by risk, from a wealth management perspective; then I’ll share my observations of how some investors view risk, and finally, I’ll share my own insights and ideas on risk management. It is important to note that there are many varying opinions on how to best manage risk; my views are not necessarily the best, but rather, I’m hoping to offer a different point of view from what is often said about this topic.

There are many different categories and subcategories of risk that affect investors, but for the purpose of this discussion, there are three types that I want to focus on:

1. Volatility (sometimes referred to as Variability, Volatility Risk, or sometimes just Risk)
2. Shortfall Risk (sometimes referred to as just Shortfall)
3. Absolute Risk (sometimes called Pure Risk)

Although these three types of risk are different, they are deeply interconnected to both an investor’s portfolio and financial plan. My goal is to shed some light on those connections and give both investors some new insights to consider.

Volatility:

When I say volatility, I’m referring to fluctuation of the price of an asset or value of portfolio as a whole. Volatility is usually measured using “standard deviation”, which measures the dispersion of a data set from its mean or average. Put more simply, volatility refers to the magnitude of the past ups and downs of an asset. For example, in image below we see two different investments: Investment ABC & Investment XYZ. The blue line traces the growth path of those investments over the same time frame. The grey line represents their average growth. As you can see, both Investments have the same average growth: that is, they both start and end at the same value. However, XYZ experienced a bumpier ride, as its ups & downs were twice the size of ABC’s ups & downs. In this scenario, we would say that XYZ was twice as volatile as ABC. We would also say that historically, XYZ carried twice the volatility risk of Investment ABC.

 

Shortfall Risk:

Technically speaking, shortfall risk is the risk that an investment’s actual return will be less than the expected return needed to meet a financial obligation. Another way to think about shortfall risk is to say that it is the risk of falling short of an investment target or goal. For example: the investor below had the goal of reaching $100,000 in seven years. Unfortunately, she was only able to reach $60,000 after seven years of investing. They now had to make choice: settle for only $60,000 or continue to save & invest and extend her time horizon.

Absolute Risk:

When I refer to absolute risk I’m talking about the type of risk that is often associated with insurance. Absolute risk is any risk where there is no possibility of gain; there is only the risk of loss. Examples would include events like: health issues, losing a job, or any sudden, unplanned expense. Absolute risk may not affect an investor’s portfolio directly, but it can damage the overall financial position of the investor, which often impacts their investing behaviours.

Now that I’ve introduced these three related risks, in the next instalment of this article will dig deeper into these three types of risk, and I’ll share some best practices I follow when trying to manage these risks while building wealth for my clients.