Measuring your risk tolerance in the markets

Investors are often told not to consider investing in equity markets if they are not in it for the long term.  For some, a year or two might seem like a long time but this should be considered the early stages of embarking upon exposure to the markets.

Here’s some perspective as to what the markets have done over the past couple of decades.  Over the ten-year period from January 1, 1998 to December 31, 2007 the S&P/TSX Composite Index returned a total 106.5%.  This represents an annualized compound rate of return of 7.5 per cent.

During the ten-year period between January 1, 1988 and December 31, 1997 the annualized compound rate of return was 7.8 per cent.  The total gain in the Index during both of these ten-year periods highlights that the stock market has an upward bias.

The actual annual percentage returns (losses) of the S&P/TSX Composite Index were as follows:  1998 (-3.2), 1999 (29.7), 2000 (6.2), 2001 (-13.9), 2002 (-14.0), 2003 (24.3), 2004 (12.5), 2005 (21.9), 2006 (14.5), 2007 (7.2).

To summarize, we noted that three years ended in negative territory.  We also noted the extremes of a gain of 29.7 per cent in 1999 and a loss of 14.0 per cent in 2002.  The above information reinforces something we already know – the stock market does not move in a straight line.

An important component to investing is having an Investment Policy Statement (IPS).   One component to an IPS is establishing your annual growth target to reach your objectives.

Do you need eight per cent to reach your objective?  Possibly you only need to earn six per cent, or maybe you feel ten per cent is your goal.  The higher annual growth you desire, the greater degree of risk you will have to assume.

Increasing risk in your portfolio does not always equate to higher returns.  High-risk portfolios run the possibility of experiencing a negative year (i.e. 2001 and 2002).  How does a negative year in the markets impact your portfolio? The table below shows how the first year investment returns effects the average annual returns required to reach respective targets of six, eight, and ten per cent.

POTENTIAL REWARD FOR RISK TOLERANT INVESTORS

Annual

First Year

                 
Growth  

Actual

Time horizon to meet your annual growth target *    
Target

Returns

         1

         2

         3

         4

         5

         6

         7

         8

         9

 

15%

    (2.3)

      1.8

      3.2

      3.9

      4.3

      4.6

      4.8

      4.9

      5.0

6%

5%

      7.0

      6.5

      6.3

      6.3

      6.2

      6.2

      6.1

      6.1

      6.1

-5%

   18.3

   12.0

      9.9

      8.9

      8.3

      8.0

      7.7

      7.5

      7.3

 

-15%

   32.2

   18.4

   14.1

   12.0

   10.8

   10.0

      9.4

      9.0

      8.6

 

15%

      1.4

      4.7

      5.8

      6.3

      6.7

      6.9

      7.0

      7.2

      7.2

8%

5%

   11.9

      9.5

      9.0

      8.8

      8.6

      8.5

      8.4

      8.4

      8.3

-5%

   22.8

   15.2

   12.7

   11.5

   10.8

   10.3

   10.0

      9.7

      9.6

 

-15%

   37.2

   21.7

   17.0

   14.7

   13.3

   12.4

   11.8

   11.3

   10.9

 

15%

      5.2

      7.5

      8.4

      8.8

      9.0

      9.2

      9.3

      9.4

      9.5

10%

5%

   15.2

   12.6

   11.7

   11.3

   11.0

   10.9

   10.7

   10.6

   10.6

-5%

   27.4

   18.4

   15.5

   14.1

   13.3

   12.7

   12.3

   12.0

   11.8

 

-15%

   42.4

   25.1

   19.9

   17.3

   15.8

   14.8

   14.1

   13.6

   13.2

 

* Required average annual return to reach stated annual growth target (with different outcomes)

An investor who began investing in early 2001 or 2002 may have a significantly different outcome then an investor who began investing in early 2003.  When we have new clients that have a lump sum to invest, such as selling a home or receiving an inheritance, we communicate the importance of reducing market risk.  Several simple strategies exist to reduce this risk.

To illustrate we will use Dan Anderson, 50, who plans to retire in five years.   Dan has been managing his own investments and has determined that he requires annual growth of eight per cent each year to reach his retirement goals.

A positive outcome after year one would be growth of eight per cent or greater.  Assuming markets are good, let’s say Dan’s portfolio returns 15 per cent in the first year.  If we look at the table we see that Dan can now reach his objective by returning only 6.3 per cent for the remaining four years.  Dan should shift his portfolio to be more conservative based on the lower annual growth requirement to reach his goal and rebalance his portfolio.

The attached table is very effective in illustrating the impact of negative outcomes.   Instead of earning eight per cent in the first year, what if Dan’s portfolio declined 15 per cent?   In order for Dan to get back on track he would have to earn 14.7 per cent each year for the next four years.  Although this is achievable, it is significantly more difficult to achieve than eight per cent annually.

The key point to take away is that portfolios should be structured with the appropriate amount of risk.  As an example, if you only require a five per cent return per year then you should have most of your money in fixed income, such as bonds and GICs, and have a lower percentage in the stock market.

As your return expectations increase, so does your exposure to the stock market.  Although the stock market is biased in the long run to increase, there will likely be both positive years and negative years over your time horizon.