Tuesday, 22 June 2010

Coping with an Uncertain Investment Time Horizon

NOBODY expects the Spanish Inquisition! Our chief weapon is surprise...surprise and fear...fear and surprise" - Monty Python TV show (quote found on Thinkexist.com)

Life is full of surprises. Everyone knows that but it is sometimes forgotten by investors, for instance when younger people decide to buy only stocks given the fact that stocks provide higher returns in the long run than bonds or treasury bills and that a young person has a long time to go before retirement.

The flaws in this thinking arise from several realities. First, retirement is by no means the only investment objective. Major future spending may be anticipated for education of self or children, house purchase, travel, sabbaticals and gifts. So there are multiple objectives to consider, all with different time horizons. And that is only the stuff which is anticipated.

Then there are the surprises, both good and bad, that life springs upon us for which we may need or want to cash in the investments. Some of the surprises, such as a job loss or health problems, may also be dealt with through buying insurance, but others may require delving into one's portfolio. A marriage can be a wonderful unexpected event that arises quite quickly. An untimely death can bring on hefty funeral and burial expenses or need to support survivors. People intending to leave gifts in their will may decide that some circumstance compels giving the money immediately. Involvement in a lawsuit may entail big legal bills. The list can be long.

The problem with stocks, the flipside to the higher returns of stocks, is that there are considerable ups and downs and sometimes lengthy periods of ten years or more during which prices lag. Recent history - the 2001 tech crash and the 2008 credit crisis - is a harsh reminder of that reality.

A 30% decline in the stock market means that much less money available to spend at that moment. It is difficult enough to save so no one wants to be faced having to cash in after a 30% decline. What can the investor do to protect against such losses and yet maintain the flexibility in a portfolio to cope with unanticipated spending needs?

Diversify - Include other types of assets within the portfolio that typically do not move in tandem with stocks. The list of such asset classes comprises REITs, commodities, bonds and cash, especially the latter two. Bonds held their value very well through the 2008 crisis as we showed in our previous post The 2008 Crash - Case Study in Diversification and generally add a lot of stability to a portfolio.

Cash is inherently ultra-stable. Cash as an asset class for investors means more than just cash in a bank account. It includes highly secure (i.e. government and corporate top investment grade), short-term (no more than five years), easily- and quickly-cashed securities:
  • Canada and Provincial Savings Bonds
  • Cashable GICs
  • Term Deposits
  • Money Market Funds
  • Treasury bills
  • Commercial Paper
  • Government and Corporate Bonds with less than 5 years to maturity
Ways to Buy
Our previous post Investment Building Blocks - Securities outlined how these products can be bought either individually or in various types of funds. Fiscal Agents publishes current rates for Cashable GICs and Term Deposits. Canada Savings Bond rates are here - note that they are only sold in annual campaigns and the next one begins in October. Contact your online broker for actual prices and to buy any of these for your portfolio.

How Much Allocation in the Portfolio
The Norm - The figure most often seen for an allocation to Cash is 5-10% of the portfolio. The recommended allocation to Bonds varies hugely - up to 75% of of the total portfolio, but it is rarely below 20%. Our previous post on Asset Allocation discusses the process of developing an allocation and includes links to tools for doing it.

Scenarios - Since everyone's life differs, one way to approach the decision is to look at your own particular situation and do a rough scenario analysis to guess what types of events could arise. Then estimate what those would cost and maintain at least that amount of your portfolio in Bonds and Cash. Doing a "perfect storm" combination of several simultaneous events adds a margin of safety.

All this is to say, beware of getting caught in a "Monty Python" event and have a margin of safety and flexibility in your portfolio.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comments are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


Canadian Couch Potato said...

This post contains an error. The Spanish Inquisition has four weapons: surprise, fear, ruthless efficiency, and an almost fanatical devotion to the Pope.

Abby said...

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CanadianInvestor said...

Potato, you are so right! Even when one thinks all risks have been identified, others are revealed. The only thing to be surprised at is that anyone should be surprised.