How much should you hold in equities relative to fixed income?
When it comes to investing and retirement planning, the old rule suggests subtracting an investor’s age from 100 to determine the ideal asset mix. For example, the portfolio of a 60-year-old should be 40% equities.
This approach gradually shifts an investor toward a more conservative plan as they age. More specifically, an advisor may increase the fixed income allocation relative to equities as each year passes. But this can be too simplistic, depending on the client’s personal situation, KYC criteria and income sources.
Further, investing is more complex today. For instance, to achieve an expected rate of return of 7.5% (pre-tax, pre-inflation), the recommended asset mix and associated risk level has changed dramatically.
According to Callan Associates’ capital market expectations, a typical asset mix of 27% cash and 73% fixed income in 1995 would have achieved a 7.5% expected rate of return and a 6.0% standard deviation.
In 2005, however, achieving the same expected rate of return required reducing fixed income and cash and introducing additional uncorrelated asset classes, such as private equity, real estate, U.S. large and small caps, and global equity. As expected, standard deviation increased to 8.9%.
Then, in 2015, an increasingly smaller slice of fixed income and greater diversification were required to achieve the same expected rate of return. However, this demanded three times the risk, resulting in a standard deviation of 17.2%.
The reality is, investors and advisors over the past 20 years have had to make an important decision: do they reduce return expectations or increase risk?
Source: Callan Associates
Addressing portfolio shortfalls
To address a portfolio’s shortfall, investors may need to accept more complexity, risk, and illiquidity. This is especially concerning for those who need short-term income. The shortfall may inappropriately increase an investor’s appetite for risk, unexpectedly extend their time horizons, challenge their investment goals, and test their investment knowledge or comfort levels.
One remedy is to provide investors with multiple investment objectives by re-aligning different asset classes to structure their goals and income streams over time. For example, an advisor may use a cash-flow account strategy to efficiently deliver income to a client. Under this strategy, a separate investment account or portfolio can continue to invest in a diversified portfolio and grow over the long term. This strategy will need to consider other sources of income, such as CPP and OAS, when determining an investor’s day-to-day cash flow needs. Moreover, longevity and inflation risks can emerge if you allocate too much to the cash-flow account relative to the overall investment portfolio.
To simplify this further, consider having three investment buckets: a short-term bucket with short-term bonds or money-market instruments; a medium-term bucket with a balanced or conservative portfolio; and a long-term bucket with a growth mandate. Over time, the funds shift from one bucket to the next, creating a waterfall effect. These tactics will require an advisor to monitor the income needs of the client, replenish the short- and medium-term buckets, and rebalance the asset allocation of each bucket as needed.
Assessing risk tolerance
The best questionnaires will not only identify an investor’s risk capacity, but will also uncover an investor’s perception or misperception of risk and how stable this perception remains during volatile markets.
In most cases, the ultimate goal is to assess a client’s tolerance and understanding of risk using both quantitative and qualitative measures. Qualitative metrics include personality traits, which inform advisors of a client’s potential reaction to market volatility if their portfolio value drops 10%, 20%, or 30% in a given year.
While it’s important to update and adjust clients’ risk tolerances on a regular basis, advisors must also educate clients about the relationship between expected rates of return and the associated risk, volatility, complexity of asset allocation and liquidity. Don’t be surprised if this level of education alters a client’s risk profile. In fact, this alteration provides a better foundation for decision making while maintaining accountability to the client’s long-term financial plan.
Explaining risk/reward trade-offs
Once you’ve accurately measured a client’s risk tolerance, it’s easier to explain the risk/reward trade-off, because you’ll know if your client is an investor focused on protection, or a speculator focused on prediction.
Coming back to the example of the three investment buckets, segregating short-, medium- and long-term investment objectives can help explain and manage the trade-off. And breaking down investment objectives into each bucket overcomes common objections. For example, with short-term needs, an investor may not expect or require a high reward. Conversely, in the long term, an investor may better tolerate volatility over the course of a typical market cycle.
Accounting for tax and inflation
Finally, advisors should consider the impact of tax and inflation.
Referring again to Callan’s capital market expectations, a portfolio of cash and fixed income in 1995 would certainly be considered less risky compared to the asset allocation required in 2015 to produce the same expected return.
But the opposite is true for inflation protection and tax efficiency in a non-registered account. In 1995, the annual inflation rate was 2.2% compared to 1.13% in 2015.
As a result, the value of the investment corroded at a faster rate in 1995, despite the portfolio producing a rate of return of 7.5%. In addition, a portfolio of cash and fixed income produces interest, which is taxed less favourably than capital gains and dividends in a non-registered account.
So once you consider these impacts, your next steps should include the following:
- Prepare three model portfolios to address short-, medium-, and long-term investment needs aligned to a client’s overall financial plan.
- Adopt a robust risk tolerance questionnaire that identifies a client’s expectations and perception of risk.
- Incorporate an investment policy statement for each investment strategy that creates a framework for decision making and accountability.
Over the last 20 years, investors have had to accept more complexity, risk, and illiquidity to maintain the same rates of return. As a result, advisors must address income shortfalls, risk tolerance, taxation, and inflation — along with compliance implications — for each client. Critically, advisors must discuss with clients upfront if they should increase risk or lower return expectations.