Measuring your tolerance for volatility and risk

People are often told not to invest in equity markets unless they have a long-term time horizon. While for some people one to two years might seem like a long time, most investment professionals feel a long term time horizon would be seven years or greater.

Here is some perspective as to what the markets have done over the past two decades in Canada. Between Jan. 1, 1999, and Dec. 31, 2018, the S&P/TSX Composite Index returned a total of 260.50 per cent. This represents an annualized compound rate of return of 6.62 per cent. Most decades the compound rate of return for equities has been declining.

The actual annual percentage returns (losses) of the S&P/TSX Composite Index were as follows:

  • 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)
  • 2008 (-35.0)
  • 2009 (30.7)
  • 2010 (14.4)
  • 2011 (-11.1)
  • 2012 (4.0)
  • 2013 (9.6)
  • 2014 (7.4)
  • 2015 (-11.1)
  • 2016 (17.5)
  • 2017 (6.03)
  • 2018 (-11.64)

To summarize, we noted that in the past 20 years there have been six years where the S&P/TSX Composite Index posted declines. For the same time period, the S&P/TSX Composite Index posted 14 years in which there were positive returns. We also noted the extremes of a loss of 35.0 per cent in 2008 immediately followed by a gain of 30.7 per cent in 2009. 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 investment objectives and risk tolerance for each account and outlining the type of portfolio you want.

The above annualized 6.62% rate of return over the last 20 years assumes a 100 per cent Canadian Equity portfolio mirroring the index. Of course, many investors may have fixed income and investments outside of Canada. With interest rates being at low levels, many investors would have opted to decrease fixed income and increase the equity component to achieve greater long term returns.

We encourage most investors wishing to overweight equities to focus on well selected medium risk securities. The higher annual growth you desire, the greater degree of risk you will have to assume. Normally this means increasing the equity portion of the portfolio. The types of equities you purchase are almost as important as the asset mix you choose. Increasing risk in your portfolio does not always equate to higher returns. When you add speculation and high risk into the portfolio, then you also add the possibility of severe corrections if the markets move in a negative direction. High-risk and speculative portfolios run the possibility of experiencing an extreme negative year (i.e. 2008 and 2015).

How does a negative year in the markets impact the investor’s 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 10 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 or 2009. When we have new clients that have a lump sum to invest from 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 a made up example of John Smith, 50, who plans to retire in five years. John has been managing his own investments and has determined that he requires annual growth of six per cent each year to reach his retirement goals.

A positive outcome after year one would be growth of six per cent or greater. Assuming markets are good, let’s say John’s portfolio returns 15 per cent in the first year. If we look at the table we see that John can now reach his objective by returning only 3.9 per cent for the remaining four years. John should consider shifting 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 15 per cent in the first year, what if John’s portfolio declined 15 per cent? In order for John to get back on track he would have to earn 12 per cent each year for the next four years. Although this is achievable, it is significantly more difficult to achieve than six per cent annually.

The key point to take away is that portfolios should be structured with the appropriate amount of risk.

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.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director, wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138. greenardgroup.com