Stock markets are unpredictable and at times completely irrational – at least in the short term. By short term we mean five years or less. Investing can be a very frustrating experience for people seeking instant gratification or short-term results when markets decline.
Prior to any investing with our clients we ask a series of questions to obtain an understanding of risk tolerance, time horizon, and cash flow needs. We have listed three of these questions below and outline the reasons why we ask these questions.
Question 1: What is your investment time horizon in years?
A) 1 to 2 years
B) 3 to 5 years
C) 6 to 10 years
D) More than 10 years
The main reason why we ask the above question relates to how conservative our recommendations will be. If someone has a time horizon of one to two years our recommendations will focus on cash equivalents and bond type investments. If someone says more than ten years, then a portfolio could have a balanced approach with a greater percentage in equities. As time horizon decreases so should the percentage in equities.
An interesting exercise for investors is to go through and look up the worst one-year returns in the stock markets. One would discover many negative one-year periods in the markets. Significant one-year declines would have seriously impacted someone that was incurring too much risk based on their time horizon. By looking at the worst ten-year historical period of returns in the Canadian stock market, investors would realize that these longer periods are actually positive. History may provide some comfort for people who are holding high quality investments and feel they will recover over their time horizon.
Question 2: As a percentage, what is your household’s annual income requirement from your investment portfolio?
A) 10 per cent
B) 7 – 9 per cent
C) 4 – 6 per cent
D) 1 – 3 per cent
E) 0 per cent
We receive a variety of responses when we ask this question. Some people are fortunate not to need any income from their investments because of age or other sources, such as pensions or rental income. Most retired people require some form of income from their investments. If investment income is the only source of income it becomes important to balance capital preservation with income. If income needs are five per cent or less then the portfolio should be heavily weighted towards bonds, GICs, and other lower risk investment options.
Question 3: Will you need to liquidate a portion of your investment portfolio over the next five years?
A) More than 20 per cent
B) 11 to 20 per cent
C) zero to ten per cent
D) No requirement
The reason we ask this question is to get an understanding of significant purchases that are planned. This may be a personal residence, vacation home, vehicle, boat, motor home, travel costs, renovation, etc. These one-time items should be itemized and timing should be noted. We recommend keeping an amount equal to these costs liquid and secure. This ensures that specific goals can be met and that short-term equity markets do not impact plans. The remaining assets can then be looked at for a longer-term strategy.
The risk zone that all investors face is the period immediately before retirement. As an example, this may be the five-year period before you begin living off of your investments.
A typical investor may have been focused on growth for 30 years or more. As an investor enters the risk zone it is important to look at shifting your portfolio to provide a future income need and capital preservation.