A financial advisor is required to document risk tolerance and how much you are willing to assume.
Every investment account should have set percentages for low, medium, and high risk. Your RRSPs, for example, may have the following percentages: 25 low, 50 medium, and 25 high. Note every account has to add up to 100 per cent. It is important for you to know what your percentages are and that they accurately reflect your risk tolerance.
One of the ways to look at risk is to look at the mirror reflection of reward. The greater the risk you take, typically the greater reward (but not always) if markets are positive. If the markets are negative, then high risk investments will typically decline more than medium risk investments. Any investor who has medium and high risk investments should be comfortable to withstand negative returns and the volatility of the markets.
Investment firms typically classify the equity investments they have coverage on by assigning a low, medium, or high risk rating. When looking at these “equity” ratings it is within the equity category only. A low risk common share is riskier than a term deposit. If on the account opening forms your stated risk tolerance is 100 per cent low risk then your advisor is limited to recommending low risk investments only. If you have a medium and high risk component then your choice of investment options increases significantly.
The account risk percentages set the framework for investment recommendations from your advisor. When we are reviewing these percentages with new clients we provide an example of what types of investments would typically be classified into the three areas.
- Low risk investments are treasury bills, money market investments, guaranteed investment certificates, term deposits, investment grade bonds, some debentures, and certain types of preferred shares.
- Medium risk investments may be most debentures, certain types of preferred shares, and common shares with up to a medium risk classification.
- High-risk include commodities, precious metals, initial public offerings, flow through investments, and common shares with a high risk classification.
One error we occasionally see is that all investment accounts have exactly the same risk tolerance. Each account should have customized risk percentages.
To illustrate we will use Mr. Warren who has the following accounts: Tax Free Savings Account (TFSA), Registered Education Savings Plan (RESP), Registered Retirement Savings Plan (RRSP), and a Joint With Right of Survivorship Account (JTWROS) cash account with his wife.
With the TFSA, Mr. Warren would like one blue chip dividend paying equity with the dividend reinvestment plan (DRIP). The risk percentages for the TFSA are: 0 Low, 100 Medium, and 0 High.
With the RESP, both Mr. Warren’s children are under five years old. He would like to see some growth for the next five years at least. We discussed how the RESP risk tolerance could be initially set for 0 Low, 0 Medium, and 100 High. In five years time we could look at shifting the portfolio more conservative (time horizon shrinks) to 0 Low, 50 Medium, and 50 High. When the children are within five years of going to school then the risk tolerance could be shifted to 50 Low, 50 Medium, and 0 High.
For Mr. Warren’s RRSP we have a ten year laddered corporate bond portfolio with a few convertible debentures. Based on the current holdings the recommended percentages are: 75 Low, 25 Medium, and 0 High.
Mr. Warren’s JTWROS is where they hold a mixture of longer term hold medium risk common shares and high risk common shares. The percentages are 0 Low, 25 Medium, and 75 High.
The following are a few steps to complete to ensure your investments are suitable given your risk tolerance:
Step 1: List all of the investment accounts that you own on a sheet of paper. Beside each one of these you should write down how much low, medium and high you are willing to assume given the type of account (i.e. taxable, registered), time horizon, and your risk tolerance.
Step 2: For each of your investment accounts obtain the current risk percentages listed on each account. Your original account opening documents would have these percentages. If you have signed any documents changing these percentages you should obtain a copy of this for your file. Compare the percentages from Step 1 and Step 2.
Determine if the percentages on your accounts are still accurate. Often at times with age and time these percentages may need to be updated.
Step 3: The last step involves you looking at each individual holding you own and determining the risk of each. This exercise is worth doing with your advisor at least annually, or more frequently if you are making investment changes. Beside each investment write low, medium or high risk. This exercise is a little more difficult when you have investments that are in the “grey area”, such as preferred shares and convertible debentures that have features of more than one risk category. For investments that have characteristics of both categories, allocate an amount equal to half for this exercise. Add up the total market value of the lows, mediums and highs. Once you have these totals, divide by the total account value to obtain an approximate percentage in each risk classification.
Step 4: Compare the estimated percentages determined in Step 3 with both the percentages in Step 1 and Step 2. The outcome from this exercise may result in either a change in account documentation (updating risk tolerance) and/or making appropriate changes to the investments.