Help! I’m too Risk-Averse to Invest
Being Cautious With Your Money
For years your friends have been telling you to invest in the stock market. You resisted, insisting that High-Interest Savings Accounts (HISAs) and Guaranteed Investment Certificates (GICs) were all you needed. Besides, you already had some money in the stock market because of the Defined Contribution Pension Plan that you participated in. You had just taken the default and that was good enough for you. You liked that you kept on putting a little in every two weeks when you got paid and that your employer chipped in the same amount.
Nevertheless, your friends insisted. They told you to look at your latest Notice of Assessment, and you learned that you had accumulated nearly $20,000 in RRSP contribution room. You were underutilizing your RRSP and sticking exclusively to GICs. And you hadn’t even opened a Tax-Free Savings Account (TFSA).
Throwing Caution to the Wind … Except it was a Tornado
Finally, accepting the encouragement, at the beginning of 2020, you took $10,000 and bought an index fund that tracked the Canadian stock market. Things looked good until mid-February when the markets tanked, and you lost 30% of the money you had invested. You sold off that loser of a fund, took the remaining $7,000 and bought an 18-month GIC. You told your friends you were done with their risky ideas.
Nevertheless, you kept on watching the market and were amazed at how well it did in 2021. Bowing to your friends’ mantra that “it’s not timing the market, but time in the market” that counts, in December 2021, when the $7,000 GIC matured, you took the principal and purchased another fund, this one tracking the global stock market. Unfortunately, 2022 was a bad year and when you finally gave up at the end of the year, you had lost another 15%. Your $10,000 investment was now worth less than $6,000.
Should You Even Invest?
Some people will never invest in the stock markets. They cannot accept risk. I am by nature a cautious person. I worked my way very slowly into the investment markets. My first mutual fund invested in Canadian money markets, essentially ultra-short-term fixed-income products. Money markets typically have maturities in the 30-to-90-day range. Next, I ventured into a mortgage mutual fund, the equivalent of a short-term fixed-income fund. Only after passing through those very conservative first steps, did my wife and I finally begin to venture into a balanced mix of mutual funds that included a substantial portion in equities, initially through an advisor at a local bank branch, then through a full-service investment advisor, and finally under my own management after a few years of working in the investment industry and a bunch of finance-related credentials.
For me, the gradual journey toward investing in equities required time and education. Others will have their own criteria that need to be met before they can accept the “risk” of short-term volatility in exchange for the potential for greater long-term expected returns.
Risk Tolerance
If you have worked with an investment advisor, including a robo-advisor, you should have been given some kind of risk-tolerance questionnaire to complete. This is a component of the regulatory requirement to Know Your Client (KYC) that every person selling investment products in Canada must meet. A common criticism is that these questionnaires were often little more than marketing tools to get the client to buy into an advisor’s recommendation. More recently, questionnaires have been improved and are more well-founded on psychological assessments.
Three Essential Factors in Risk Assessment
Risk tolerance assessments seek to assess three factors in determining an appropriate level of investment risk: capacity, ability, and need.
Capacity for Risk
This might be termed the objective gatekeeper into investment risk. Do you have the financial ability to handle an investment loss without affecting your financial well-being and meeting essential financial goals? For example, younger people with stable employment and incomes that are meaningfully greater than their expenses are likely to have a greater capacity for investment risk than older people at the end of their careers with commission-based jobs who are one paycheque away from insolvency. Boiled down to four subfactors, the capacity factor can be assessed by reviewing:
Income and Expenses
Higher income and lower expenses provide a higher capacity for risk since there is more disposable income to invest.
Wealth and Assets
The more wealth and the greater the existing assets, the greater the capacity for risk. You may wonder why “the rich get richer.” This is part of the reason. Those who are wealthy can tolerate the risks that allow for more wealth to be generated.
Time Horizon
A longer investment time horizon allows for a higher capacity for risk, as there is more time to recover from any downturns in the market.
Debts
High levels of debt can reduce the capacity for risk as the financial resources to absorb losses are limited.
The number of households that have an abundance of all four factors is rare, I suspect. For example, a young woman fresh into a new job after graduating from a post-secondary educational program may be earning the lowest income of her career at the moment, but if she’s learned to live frugally while a student, she may also have relatively few expenses. However, it is also unlikely that she has much in the way of wealth. On the other hand, she has a long time horizon. Her career may go on for forty years or more and she may have another 30 or 40 years after that. Nevertheless, she may have graduated with significant debt that requires her to focus much of her excess income on paying it down.
An older, retired or nearly retired man may have just the opposite situation to contend with. A retired man may have a pension or other forms of savings set aside for retirement, but the ability to earn more income through a new job is probably gone. He might have a fair bit of wealth, but again, it is all earmarked to support the uncertain years that remain. That is, the time horizon is shortened. Finally, while debts are often dealt with by the time older people reach retirement age, it would not be too surprising if he had entered retirement still having a mortgage to pay off.
Ability for Risk
If capacity is objective, then the ability to handle investment risk refers to the subjective, emotional, and psychological aspects of risk tolerance. Here, the goal is to understand how you might react at a “gut level” to the inherent volatility of the investment markets. Subfactors of the ability for risk include:
Risk Aversion
People have a wide range of attitudes toward risk. I don’t know enough about the research to understand how much is a product of upbringing versus something in one’s nature, but some live for thrills while others prefer safety above all. The latter person is likely to be risk averse for their investments as well, uncomfortable with even moderate levels of uncertainty or volatility. This is the person who will only invest in GICs and keeps plenty of cash readily available.
Past Experience
In 2008-2009, when the markets tumbled dramatically around the world, I was working at a discount brokerage here in London, Ontario, but licensed to serve DIY investors in the United States. Most of these were risk takers, actively trading stocks or options in hopes of beating the market. They also tended to borrow against the value of the investments, “buying on margin,” to use the investment terminology. When the stock market indices began shedding 100s of points a day, these DIYers were caught on the wrong side, and many found that their accounts had become worthless. I remember speaking with one man some years later who had gotten out of the market at that time and had kept what was left of his account in cash or equivalent products for the subsequent five years.
At the other end of the spectrum, I remember one investor who observed that the “Great Financial Crisis” (GFC) was a once-in-a-generation opportunity to invest when the markets were appreciably lower than they had been. “Everything is on sale.” He was an older man who had lived through a few market downturns, understood the risks, and had not invested beyond his ability to cope with the new situation. He could also see beyond the current turmoil to the likelihood of an eventual recovery.
In short, previous experiences with investments and market fluctuations will influence your ability to take risks in the market.
Emotional Response
Your emotional response to financial losses or gains can also indicate your ability to handle investment risk. If you become overly anxious or stressed during market downturns, you may have a lower ability for risk. I will confess that in early 2009, I was personally anxious about all of our investments, but I was most concerned with and eventually took action to reduce the risk in the Registered Education Savings Plan (RESP) we had for our four children. Three of the four were in university at that time. In retrospect, I believe we had left the asset mix in the RESP overly tilted toward risky assets.
I should say, though, that after experiencing the GFC, when the markets took their tumble in the immediate aftermath of COVID in February 2020, I was relatively relaxed about it and even used the opportunity to rebalance our accounts. In other words, experience helped my emotional response. I could say the same about 2022 as well, which was generally a poor year for investors.
Need for Risk
This sounds like another psychologically oriented assessment, but that’s not the case. Here the concern is about whether the current level of investment returns can meet a person’s spending needs. Some of the sub-factors in this category are:
Financial Goals
A household may have multiple financial goals: saving for retirement, funding education, or purchasing a home, to name three possibilities. These have distinct time horizons and, therefore, risk tolerances will likely vary among them. Saving for retirement, for example, could be an endeavour that takes more than 30 years, and the resulting assets need to last for another 30 years, so you may need to take more risk to adequately fund that goal. If you want to fund your children’s education, on the other hand, you typically have about 18 years to set aside the money followed by having it spent down in two to four years or so. Purchasing a house will have yet another financial need profile. If the goal is to save up for a down payment over five years, for example, you will want to keep that money in risk-free investments like a HISA or possibly short-term GICs.
Inflation and Cost of Living
Inflation is a difficult challenge. Bonds, the usual hedge against a volatile stock market, will react negatively to an increase in inflation and the subsequent increase in interest rates. Stock markets also tend to respond negatively to unexpected inflation, at least initially. Finally, cash or cash equivalents like GICs will tend to respond in line with inflation, but they do tend to lag behind the cost of living, at least initially. What to do? Well, in this case, the risk-averse investor should probably do what any investor should do at any time: hold a globally diversified portfolio of investments, including equities. I will direct readers back to a blog post that reviewed a Rational Reminder podcast, called The Ultimate Inflation Hedge. In his research, Ben Felix found that from 1966 to 1982, when inflation caused U.S. stock market returns to return zero after inflation, Canada and the United Kingdom had positive real returns. This suggests that there is a need to take at least some degree of globally diversified investment risk to mitigate the financial risk posed by inflation.
Income Replacement
Finally, there may be a need to take some investment risk simply to sustain the income needed for retirees or others who rely on investment income to cover their living expenses. As has been mentioned already, those who retire at the standard age of 65 have a strong possibility of living until age 90 or longer. FP Canada issues guidelines about probabilities of survival that draw on the work of actuaries. They further recommend using a 25% probability of survival to encourage a conservative approach to spending in retirement. In that case, a male between the ages of 55 and 65 has a 25% probability of surviving to age 94, a female to age 96, and in the case of a male/female couple, one has a 25% chance of living to age 98.
One can mitigate this risk by delaying the start of the Canada Pension Plan (CPP) and possibly Old Age Security (OAS) payments until past 65 (up to a maximum of 70). If you have a defined benefit pension plan from your employer, you have an additional source of reliable lifelong retirement income. There is also the option of buying a steady stream of income in the form of an annuity with your retirement savings. But, given that few people like to delay CPP or OAS, fewer still have access to defined benefit pension plans, and even fewer are interested in buying annuities, the option left to increase one’s odds of having a lifetime of income is to add at least some risk to your investment portfolio by investing in equities. Doing so will improve the probability of greater long-term expected returns.
OK, I Need to Invest – Persuade Me!
Let’s suppose that a risk tolerance assessment shows that you have the capacity, ability, and need to invest in risk assets, but you have never done it successfully before over the long term. What are some arguments in favour of making the leap from GICs to equities?
Historical Performance
Over the long term, equity markets have shown the potential for higher returns compared to other asset classes like bonds or cash. To be sure, if you invest in equities, you will experience short-term volatility, but history demonstrates that equity investments have outperformed inflation, which supports the expectation – but not the guarantee! – that you will build more wealth over time than by sticking with more conservative investments.
Diversification Benefits
Including equities in a diversified portfolio of investments can reduce overall risk. By mixing different asset classes, even if you are risk-averse, you can achieve a balance between growth and stability, and thereby limit your exposure to the risk from any single asset category.
Tax Advantages
In Canada, equity investments come with certain tax benefits. Now this may only have meaning for you if you invest beyond accounts like RRSPs and TFSAs, and use non-registered accounts, too, but it is worth considering. Dividends from Canadian equities have special tax treatment that may be advantageous over interest paid at the same percentage of investment, but I think the real benefit comes from the treatment of capital gains and losses. If you sell an equity share for a capital gain in Canada, that is, for more than your cost, only half of the gain is taxable. And, on the flip side, if you sell an equity share for a loss, you can use that loss to reduce other capital gains you may have realized or will realize in the future. This rule applies regardless of whether the equity investment is Canadian or is from the US or another country’s stock markets.
Long Time Horizon
I don’t recommend equity investing for short-term goals like saving up for a down payment on a house or buying a vehicle, but as I’ve mentioned already, for saving up for retirement, equities can be the ideal investment vehicle. A caveat, though. As you get closer to using that money that is being saved for retirement, remember that a portion of it has a shorter time horizon. You would do well to gradually “de-risk” your portfolio accordingly.
Regulation and Oversight
Many people have the impression that investing is gambling by other means. They are mistaken. Equity markets are highly regulated. This does not eliminate the risk of loss. A business that is poorly run will probably go under eventually, despite regulation. However, this argues for diversification, that is, following the adage of not putting all your eggs in one basket, rather than not buying eggs at all. Do not buy individual stocks!
Getting the Ball Rolling
First, I suggest that anyone hoping to get started in investing in equities start slowly. One way to approach this is through “dollar-cost averaging,” dividing the lump sum you have available to invest into several parts, investing a portion each month until you have reached your target. That way, you diminish the impact of a significant investment loss. But if your capacity, ability, and especially your need for risk suggest you should invest more in equities, don’t take too long. I would also say, though, that you don’t need to invest in risky assets more than necessary. “If you have already won the game, why bother to keep playing?” In other words, don’t take more risk than you need to meet your goals.
Second, and finally, educate yourself along the way. Read blog posts by people with solid credentials. Read books as well. There are some great ones out there. Dan Bortolotti, creator of the Canadian Couch Potato blog, has a great book for the DIYer called Reboot Your Portfolio. By the way, Bortolotti and his colleagues are also investment advisors, so don’t think that the DIY approach is the only or the best approach to take. If you need or want an advisor, seek one out. Or, if you are looking for something in between, consider a robo-advisor. Alternatively, if you want to go the DIY or robo-advisor route but need to set your investing in a larger context, consider an advice-only financial planner. You can find lists here and here.
In other words, there are lots of great options to get started. And, if you have any questions, feel free to reach out.
This is the 208th blog post for Russ Writes, first published on 2023-07-31
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
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