Holiday cheer alternative - Investing in wine and whisky

Forget gold. Laugh if you wish but wine and whisky can also be considered an investment. In The Price of Wine, professors Elroy Dimson, Peter Rousseau and Christophe Spaenjers recently discovered that top grade French wines (Haut-Brion, Lafite-Rothschild, Latour, Margaux, and Mouton-Rothschild) outperformed government bonds with annualized real returns of 4.1% between 1900 and 2012 as the chart below from the paper shows.

(click to enlarge)

The wine didn't do as well as British equities on a straight financial basis but it seems that there is a non-financial "psychic return" of at least 1% from the pleasure of owning wines. What stock could possibly give the same fun as owning a rare famous vintage?

Note their finding that the highest rates of appreciation were for young high-quality wines that are still maturing. There are plenty of easily-found online websites selling such wines whose prices range upwards from thousands of dollars a bottle. Or we could do like Chinese billionaires who are apparently snapping up whole French chateau vineyards.

Whisky is well on its way to emulating wine as an investment. The single malts of Scotland, produced in limited quantities and flavoured in subtle ways un-reproducible anywhere else in the world have been growing in popularity by leaps and bounds according to the BBC. The very rare and very old bottlings can command enormous prices - witness the record-breaking bottle of Macallan 64 year old, yes ONE bottle, that sold in 2010 for $460,000 US dollars ($490,000 Canadian dollars). That's more than a famously expensive share of Warren Buffett's Berkshire Hathaway stock. It's liquid gold indeed.

The Current Record Holder - Macallan 64 in a Lalique crystal decanter

It's now possible to find mainstream media articles on the best whiskies to buy as an investment, such as this one from Huffington Post. There are even indices of "investment grade scotch", some of them strongly upward sloping, but others showing losses. Popularity and price can be fickle. Another article asks whether the boom can continue. Of course, apart from the usual investment risks, wine and whisky face a very special risk, chillingly demonstrated in this YouTube video about a special bottling apparently owned by none other than Prince William.


Bottom line: Drink, and invest, carefully and responsibly!

Disclosure: This blogger owns several bottles of fine wine and single malt whisky, though they all succumb to that other behavioural investment risk, consuming the profits.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

What are the important long term investing risks? (Volatility is NOT one of them)

Last week's post on the riskiness of stocks in the long run highlighted the fact that historically equities have performed very well over long holding periods despite being subject to massive gut-wrenching declines in the short term. Today we'll look more closely at the long run risks that can cause significant permanent loss of capital even to stocks (i.e. no bounce back happens!), as laid out in Deep Risk, William Bernstein's new, very readable, mini book. Importantly for investors, equities, bonds and cash / T-Bills behave differently in response to long term risks, which he calls Deep Risk, than short term risk, which he terms Shallow Risk. It's evident that figuring out our own investment horizon is critical to building a portfolio to cope successfully with the relevant risks.

What is long term?
Bernstein means 30 years or more, a very long time but still well within an investor's lifetime horizon, even a retirement horizon nowadays.

What does he define as risk?
It's not a statistical measure like standard deviation; rather, it's an intuitive yardstick focused on the downside, permanent loss of capital, meaning a negative real after-inflation returns after 30 years. Shallow risk happens when the loss is recovered within a few years, such as the 2008 equity market crash. That's what volatility is and where it fits into the risk picture - a short term drop that is quickly recovered. Deep risk is when there is permanent loss. Finally, the measure of risk includes its magnitude - a small though though permanent loss doesn't matter much. It's losses big enough to be devastating to the investor that matter.

The devastating long term Deep risks and the effect on major asset classes
1) Inflation = Hyper/High 8+% price rises sustained for many years. Low steady inflation such as we have been experiencing in Canada for the past 15+ years, doesn't hurt any of the major asset classes.

• Losers: long term bonds, T-Bills
• Winners: equities, especially commodity producers, real return bonds

2) Deflation = Sustained economic stagnation with associated falling prices, such as the Great Depression of the 1930s. Bernstein thinks that this particular risk is much less likely today since most episodes of deflation, including the 1930s, happened when the world operated on the gold standard and now central banks can counter deflation by printing money.

• Losers: equities
• Winners: long term bonds, T-Bills, gold gold (now that's a surprise since the popular image is that gold protects against inflation but he cites data showing that it counters inflation poorly; author and financial analyst James Montier comes to same conclusion in No Silver Bullets in Investing; gold is portrayed as worthwhile insurance for times when investors have lost faith in the government, which is more typical of severe economic depressions)

3) Confiscation = Government takes your money, giving pennies on the dollar for assets, or hikes taxes to levels of expropriation. High debt levels and large growing fiscal deficits of governments are obvious warning signs of possible government desperation that might incite confiscation.

• Losers: potentially anything can taken, when governments are desperate, nothing is sacred
• Winners: foreign-held assets that your own government cannot grab, such as property; alternatively, leaving for another country that will not confiscate assets can work but it's a drastic measure

4) Devastation =  War which destroys capital and people. It's the ultimate bad outcome for an investor. Some forms of worldwide devastation, such as potentially harmful climate change, which he names, or pandemics, may offer no place to hide. In that case, total permanent loss of investments wouldn't matter anyway.

• Losers: no assets are safe
• Winners: foreign assets if the conflict is localized

Of course, in addition to the severity of harm, the likelihood of the threat must be taken into consideration. The good news is that for Canadians, the most likely threat is inflation. With a central bank ever ready to keep deflation at bay by printing money, with a government financial situation among the best in the world and with a stable civil society offering relative peace, inflation is the prime menace. It too seems to be relatively benign at the moment. So, as investors and as citizens, we have much to be thankful for at this holiday time.

Bernstein's parting words are simple and direct: "This booklet's primary advice regarding risky assets is loud and clear: your best long term defense against deep risk is a globally value-tilted diversified equity portfolio, perhaps spiced up with a small amount of precious metals equity and natural resources producers, TIPS [which are the US version of real return bonds], and if to your taste, bullion and foreign real estate." It's interesting that the TSX Composite index is already quite "spiced up" with a heavy weighting in precious metals and resources producers (11+%, vs only about 3% in the US total equity market), so investors with a broad Canadian equity holding like iShares S&P/TSX Capped Composite Index Fund (TSX symbol: XIC) have that part accomplished naturally. Another reason to count ourselves lucky!

Bottom line
The cautious investor has two main action takeaways from a look at long term risks:
i) Match investment assets and spending liabilities - control risk by matching a) near term spending plans with assets that can easily be cashed and are not subject to volatility, which is the main short term risk (e.g. T-Bills, GICs, money market funds, short duration bonds) and b) longer term spending, like a distant retirement, with assets that cope well with the biggest (impact x probability) long term risk - equities.
ii) Diversify - since most people have multiple investment goals and therefore spending horizons, it makes sense to keep some of the several types of assets.

Merry Christmas to readers!

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

Are Stocks less, or more, risky in the long run?

Today we look at an investing question that divides investing and finance heavyweights like Vanguard founder John Bogle, Wharton School professor and best-selling Stocks for the Long Run author Jeremy Siegel, Princeton professor and best-selling A Random Walk Down Wall Street author Burton Malkiel, Boston University professor and standard finance textbook Investments author Zvi Bodie, Nobel winning economist Paul Samuelson and even 2013 Nobel laureate Robert Shiller, amongst many others. The subject of their dispute: whether an investment in stocks gets more or less risky as years invested rises. Surely such a straightforward question should be easy to answer and not subject to disagreement amongst such smart, well-informed people who aren't cynically trying to deceive us. The answer is important to deciding whether it makes sense to invest more in stocks when one's investing time horizon is longer.

Why the disagreement? It seems that much of it arises from differing meanings of risk. So we shall present the arguments and readers can decide which they think is best.

First, we'll point out that the debate is not about owning the stock of a single company. Companies regularly do go belly up and short term success can turn into total failure and loss of capital and most companies have a relatively short life (and it's been getting much shorter). Rather the debate is about owning a widely diversified index of stocks, such as the TSX Composite in Canada or the S&P 500 in the USA, where the losers like Nortel continually disappear and get replaced by new vigorous upstarts. Owners of iShares S&P TSX Capped Composite ETF (TSX symbol: XIC) or SPDR S&P 500 Trust ETF (NYSE: SPY) may not even notice, and probably don't care, about any of the hundreds of component holdings inside. It's what happens to the ETF over longer and longer runs that matters.

Less risky (Siegel, Malkiel, Bogle)
The justification: History tells us that the longer the holding time period, on a basis of real/inflation-adjusted, buy and hold, total return/ reinvest dividends,
i) the lower is the range of minimum to maximum returns, 
ii) the lower is the chance of making a loss, 
iii) the progressively smaller is the maximum negative return, turning into a progressively larger positive return.

The chart below, from Siegel's 4th edition (the 5th, updated for data through the recent financial crisis, is to be released in January), shows the numbers from 1802 to 2006 for the USA

Beyond about 17 years holding period according to Siegel, stocks never had a negative holding period return while both bonds and T-Bills did due to high inflation at certain times. Through all this time period, stocks earned an average compound real 6.5% total return following a trend line where some years of deviation above or below meant going the other direction eventually.

It is possible to slice and dice the data differently, for example by starting and ending in a month/year combination (see the IFA Index Calculator and pick S&P 500 in the IFA Index drop-down menu of box 1) rather than the calendar year ends that Siegel uses. Unfortunately IFA doesn't have bond and T-Bill data. But it does have S&P 500 through the financial crisis data up to 2013. The numbers for time periods will vary but the same patterns emerge. An investor in the S&P 500 who had bought 15 years before in 1984 and sold out in panic at the bottom of the credit crisis in March 2009 would still have realized a 3.33% annual compound return.

Start in 2008 and end in March 2013 through the lost decade of the 2000s and the investor would have realized a puny but positive 1.79% compound annual return.

The big questions regarding this argument:

• USA stocks have done better than almost every other country over the long term (as can be seen in the Credit Suisse Global Investment Returns Yearbook 2013). Will the future be like the past and that success continue long enough for present-day investors not to worry that all hegemonies eventually end? Could the USA go the route of Japan, whose stocks lost 2/3 of their value in the 13 years between 1989 and 2002 (Global Financial Data Inc describes the wild ride of Japanese stocks through the 20th century). It would be foolhardy to try to assert certainty so stocks can never not be risky in this sense. 
• Canada has achieved similar though slightly lower long term compound real stock returns than the USA per Credit Suisse at 5.7%, well above the world average of 5.0%. However, there is no Canadian Jeremy Siegel to have provided the detail for this country. Are we another "lucky country"?

More risky (Bodie, Samuelson, Shiller)

Justification #1: The spread of possible ending dollar values gets wider, not narrower, with time. Though the probability of loss may decline and the possible range of rates of return may lessen, the effects of compounding over longer time periods means that the investor faces a broadening fan of ending total dollars accumulated. In the more technical language of a popularized explanation by Northwestern University professor John Norstad, "The standard deviation of the total continuously compounded returns increases in proportion to the square root of the time horizon. Thus, for example, a 16 year investment is 4 times as uncertain as a 1 year investment if we measure "uncertainty" as standard deviation of continuously compounded total return". The theoretical chart he posts is this:

... and a chart published by FinaMetrica from the real world of the widening spread up to 120 months/10 years holding period in Australian stocks (which over the long term bested the USA compound stock returns). Note that after ten years the worst outcome would have seen a real loss, though the amount lessened progressively from 24 through 120 months holding period just like Siegel's US chart.

So the argument is that if stocks behave as they have in the past, stocks are "risky" because holding on for 15+ years means a widening difference between a more and more decent amount of money and filthy to obscenely rich.

Justification #2: Stocks may have lengthy episodes of underperforming bonds or T-Bills. It's true and we have just lived through such a period. The Credit Suisse Yearbook tells us that for the 12 years between 2000 and 2012 in Canada, the TSX underperformed long term government bonds by 3.2% real return annually. However, the TSX did provide a 3.4% positive return per year. Again, it's a case of well off vs really well off. If possibly not keeping up with the Joneses is your measure of a bad outcome, then stocks are indeed risky.

We also note, that starting at ten years holding period, in the chart from Siegel the worst return of stocks at -4.1% turned out better than the worst return of both bonds (long term US government bonds) at -5.4% and US Treasury T-Bills at -5.1%. An investor lost less money with stocks than supposedly safe T-Bills.

Justification #3: The distribution of possible stock values from year to year varies more and more the longer the holding period. The idea here is that market declines any time during the holding period, not just at the end, may matter. Mark Kritzman has highlighted the fact that the longer you are in the market the more likely your are to be exposed at some point to bigger negative returns. Volatility will manifest itself. He says it matters for institutional investors like foundations whose spending is limited by account value thresholds, financial institutions with reserve requirements or hedge funds with margin limits, or for a homeowner whose mortgage requires him/her to maintain a certain net worth.

A corollary is that your actual holding period may be a lot shorter than the intended holding period. You may panic and sell out much earlier than intended. Apparently, research firm Dalbar has found that the average fund holding period of US investors is only 2.5 years (cited by Jack Duval in The Myth of Time Diversification), which is much less than the 15 to 20 years it took historically to always get a positive return from stocks. As the comic strip Pogo long ago said, "we have met the enemy and he is us". Other bad events that could shorten actual holding period like health problems, job loss, unexpected early retirement, disability mentioned by Duval are challenges that we feel should be addressed by insurance, emergency funds or shorter terms assets like GICs. If your risk tolerance and your risk capacity, or your risk need, are not suited to it, you shouldn't own much stocks.

Justification #4: Famous finance professor theorists tell us so. Paul Samuelson (see summary explanation without the math in Duval's paper) uses utility theory and the possible growing magnitude of loss to come to the conclusion that merely increasing time horizon does not justify an increased portfolio allocation to stocks. The crux of the matter is the same as in Justification #1 - is it possible that stocks will deliver a lengthy string of negative returns creating bigger and bigger losses the longer the holding period, instead of what has happened historically as Siegel documents? 

Zvi Bodie used option pricing theory to prove in the paper On the Risk of Stocks in the Long Run, that the risk of stocks increases with time because the cost of insuring against earning less than the risk-free rate goes up with time. There are no options on any stock index extending out to 15 or 20 years that would back up the theory with fact, though there is some evidence with LEAPS going out up to three years that the option price does increase for a longer term. This paper is widely cited and for most seems to be the definitive statement though British actuary David Wilkie, musters plenty of math as he disagrees - "Bodie's conclusion is unambiguously wrong". To perplex us all, Wilkie instead concludes that "The risk of stocks may increase with term, or fall, or rise and fall, or fall and rise, depending on the form of the guarantee and the measure chosen to represent risk".

So there it is, the various arguments for why stocks might be more or less risky in the long run. Take your pick. The situation reminds us of that long past TV commercial now on YouTube which debated whether Certs is a candy mint or a breath mint.

Bottom Line: We believe the proposition that investing in stocks does pay off in the long run. We are optimists, as professors Elroy Dimson, Paul Marsh and Mike Staunton painted the dominance of equities worldwide over more than a hundred years in Triumph of the Optimists. However, we think it worthwhile to be cautious and not to invest exclusively in stocks even with a time horizon of decades. Fixed income and cash-like investments make sense for near term spending or if our time horizon gets shortened unexpectedly. Other asset classes also work well in a portfolio to take advantage of rebalancing when they respond differently to varying economic conditions. Diversifying beyond Canadian and US stocks makes sense too.

Disclosure: At the moment, this blogger's portfolio is about 65% invested in stocks and stock ETFs worldwide.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

What's up, or should we say down, with REITs?

Investors with real estate holdings (REITs) have been feeling the pain of downside through the past year. While the overall Toronto stock market has moved higher, real estate has fallen quite noticeably. The Yahoo chart below shows the price movement of the three Canadian ETFs that track real estate - iShares S&P / TSX Capped REIT Index Fund (TSX symbol: XRE), BMO Equal Weight REITs Index ETF (ZRE) and Vanguard FTSE Canadian Capped REIT Index ETF (VRE) - against the benchmark for stocks - iShares S&P/TSX 60 Index ETF (XIU).

Performance is not quite so bad on a total return basis once distributions are added back to the above price chart but it is still negative. Why? What bad event has affected REITs and what can we as investors expect in future? Is there a buying opportunity?

The primary culprit - a rise in interest rates
REITs are investment vehicles mainly designed to provide steady and relatively high income. As such, they get compared to other income vehicles like bonds. Observe that the big slide downwards for XRE, ZRE and VRE occurred in the spring when interest rates took a leap upwards.

Does that mean if and/or when interest rates rise again REITs will get a further smack? It could be, according to the excellent October 2013 Canadian REITs Monthly report from CIBC (found posted on an Investor Village chat thread where various investors discuss implications - well worth a read). The sharper and faster interest rates rise, the worse the damage. The CIBC analysts estimate that a further 1% rise in the 10-year Government of Canada bond rate could entail an 11 to 12% further drop in REIT prices. That would certainly hurt but the report goes on to point out a lot of positive factors affecting REITs.

Business conditions and operating fundamentals are still favourable for REITs

• Demand and supply conditions in the various REIT segments (office, retail, industrial, hotel, apartment, retirement homes) remain positive; there are certainly no big negative changes apparent
• Debt refinancing costs at current interest rates are only a threat to increase for REIT's around 2017 and debt loads for most REITs are within prudent bounds
• Cash distribution levels look to be sustainable though for many REITs the future will likely see a lower rate of cash distribution increases
• REIT yield spreads versus bond alternatives are still high by historical standards and REIT unit share prices seem to be attractively priced; REIT prices appear to have priced-in an expected higher level of bond prices a year from now 

Bottom line, it's unlikely there will be a big recovery in REIT prices. But REITs will continue churning out steady income as they were designed to do (and as we saw a few months ago when we compared XRE cash distribution to other sector ETF s and XIU for the past decade).

REIT income has attractive tax qualities

REITs distribute a lot of Return of Capital and Capital Gains. ROC is effectively deferred capital gains (for how this works, see our popular post Return of Capital: Separating the Good from the Bad) and capital gains itself is taxed at half the rate of the ordinary interest income paid by bonds. For holdings in a non-registered taxable account the lower tax rate is a big advantage, as we showed in this post comparing the tax efficiency of various ETFs, including XRE. CIBC's report lists the tax-type breakdown of distributions for individual REITs in 2012 in Exhibit 48, while the distributions tabs for XRE, ZRE and VRE shows the breakdown for every year of each ETF's existence. We can see, especially with XRE which launched in 2002, that ROC and capital gains make up the majority of the income year after year. Note that ROC in a taxable account must be used to reduce the Adjusted Cost Base of the holding and if ever the ACB turns negative, that becomes a capital gain that must be reported and taxed in that year (see a step by step illustration in Appendix 2 of Deloitte's classic 2004 REIT Guide). For an investor in the top marginal tax bracket who may lose half of the income from bond interest to tax, REIT cash distributions can leave significantly more in the pocket than bond cash distributions. The larger REITs are now paying out 4 to 8% cash yields while a bond ETF like iShares DEX Universe Bond ETF (XBB) pays out only 3.2% cash.

Investment options
The easiest and quickest way to buy into Canadian REITs is through the three ETFs we mentioned at the start. The limited universe of REITs in Canada ( for lists of REITs see appendices in the CIBC report, or check a summary by sector in Wikipedia) means there is a lot of overlap in the ETFs but there are appreciable differences in holdings and especially in weightings (see Couch Potato's comparison).

Alternatively, for an investor with enough capital, it is possible to assemble your own basket of REITs by simply buying a piece of each of the biggest ones, much like an ETF. Then again, one can try finding the best value REITs. Certainly the individual REITs have not all gone down this past year by the same amount. Amongst the major REITs, Dundee (D.UN) has fallen the most - a 24.5% one-year price fall and a negative 18.5% total return. Yet it is profitable and its financials look reasonable, except that CIBC expects no growth. A Stockchase thread summarizes what seem to be a mixed bag of analyst opinions on Dundee. Is it a buy? It's hard to tell and more research than we have done here would be required to develop a firmer opinion. Some have even risen in price, like Canadian REIT (REF.UN) up 1.2% in price with 5.0% total return. CIBC gives its ratings in the report but they may not be correct. This recent Globe Investor story suggests that company insiders think REIT are oversold. Opinions abound.

In any case, almost all recommended portfolio allocations beyond the simplest dual stock and bond combination include a 5-10% real estate holding. REITs' excellent diversification qualities by being uncorrelated with stocks (currently close to zero per page 22 of the CIBC report), except at extreme times of financial crisis, justifies that inclusion. Most investors can thus take a long term view, confident that REITs will be around a long time, despite swings of price and interest rates, and rebalance their portfolio when the REIT allocation rises, or in this case perhaps drops, beyond the target limit set by the investor's policy statement.

Disclosure: This blogger owns holdings in most of the major Canadian REITs, including D.UN and REF.UN and BMO's ZRE ETF.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

Risk Need - Figuring out how much risk you need to take

Risk is always part of investing but how much do you actually need to take? The last component of any investor's risk profile to go along with risk tolerance /attitude and risk capacity is the need to take risk. The illustration below from Vanguard's booklet Investment risk and financial advice shows that all three elements need to be accommodated and in sync.

Trade-offs must be made - Before addressing the question of how to figure out how much risk to take, we must widen the context a bit more to the other key variables about which the investor can make decisions and trade-offs. The diagram below by Rob Brown in Risk Tolerance Questionnaire Failure sums it up - choosing more of one element means more or less of one or more others.

He defines the six inter-twined elements as: 1) Spending - how much is desired / needed to be spent i.e. the financial goal; 2) Savings - how much is to be saved; 3) Timing - when is the spending or savings to occur; 4) Risk - how volatile is the investment portfolio; 5) Legacy - how much is to be left to heirs or a charity and 6) Surety - how certain of the outcome does one want to be. We believe that this diagram could be simplified since Legacy is just another form of spending and Surety is just a net result of all the various risks attached to investing, including volatility and many others. However, the principle remains the same and is very useful for making decisions.

No Single Optimal Solution - The key point is that a person must make trade-offs - a lower spending goal or a higher savings rate means less necessity to take on risk, or deferring a goal, such as delaying retirement, can mean less need for risk too. The result is that there is no cut and dried single optimal arrangement for any investor overall, or even any single goal and no single best portfolio allocation either. There are choices to be made.

Take on only as much risk as you need - It is simple and perhaps blindingly obvious to many readers but why should anyone invest in a portfolio that is riskier than need be? If a high savings rate is joined to modest spending plans, it may be possible to achieve those goals investing in tried and true GICs. Why bother with anything else if that is the case? On the other hand, ambitious spending goals with limited savings may require a very high rate of return, perhaps unrealistically high, and a portfolio whose chances of disappointing are high as well. How does one know what is realistic?

The past as an indicator of the future - Though past investment history is not at all guaranteed to repeat, it can be a very useful guide, especially in seeing the contrast between performance of different portfolio allocations over different time periods, varying through good or poor economic growth, high or low inflation, rising or falling interest rates, wars, recessions and the like. Fortunately, there are several free online resources that allow us to see what happened in the past.
1) FinaMetrica's Investment Risk and Return Guide and Reports for Canada - The Guide gives the breakdown of 11 portfolios ranging from Very Conservative to High Growth, containing a progressive mix of cash, two types of bonds and three types of stocks. The portfolios are realistic and could be purchased today using index ETFs. The downloadable pdf Reports of five pages for each portfolio describes investment outcomes in very informative tables and charts that really gives a sense of the risk involved for the data period covered of 1973 to 2012. An interesting unique feature is that the reports compare portfolio performance to GICs. Below is a sample image of some of what appears in the report for Portfolio 7 (60% equity, 40% fixed income). The 10-year result for an investment starting in 1973 was decidedly disappointing compared even to one starting in 2003. Recall that inflation raged in the 1970s and the bond holdings took a big hit. Do we want to bet that inflation will remain under control and interest rates won't rise a lot, which would again hit bonds hard?

2) StingyInvestor's Asset Mixer - This is an interactive tool that lets anyone enter their own portfolio allocation and time period, the year coverage varying from 1970, for the majority, to as late as 1992 for real return bonds (when they first came to market). It allows the investor to enter a pseudo-MER, in the "alpha" input cell, in contrast to FinaMetrica which used pure index data i.e. no return deduction for management fees and expenses. The results can also be shown in real after-inflation, or nominal terms. Unfortunately, there isn't a box to enter an annual contribution in the model, only an annual withdrawal, which will be useful for those looking at a post-retirement scenario. A screenshot of part of the results for an almost identical 60/40 portfolio to the FinaMetrica Portfolio 7 is below. An investor who had stayed invested for 40 years while rebalancing annually along the way would have done quite well.

3) Index Fund Advisors Index Calculator - This calculator is also inter-active and allows entering an initial lump sum or annual contributions, or withdrawals, and varying time periods, going all the way back to 1928. The IFA tool shows US data for US investors only but since Canada often parallels US markets, though not year by year, over the long term it has experienced close to the same growth. The screen image of the output for a roughly similar (the individual asset classes would be US-oriented) 60% equity 40% fixed income portfolio shows about the same total growth over 1973 to 2012. It's interesting that the US investor's portfolio dropped 28% in 2008, while the Canadian version, according to the Stingy output about, only fell 14%. Recall that during the crisis, the Canadian dollar fell sharply as the safe haven US dollar rose, thereby much limiting the drop in value of US assets when translated to Canadian dollars. Diversification helped!

By experimenting with different asset allocations, initial investment lump sums, savings/contribution rates and withdrawal rates, it's possible to work towards those trade-offs mentioned above. Those who are approaching a crucial point like a retirement date can contemplate what effect another worst case year could have and decide whether a recovery lasting a likely two years (2008 US investor) or seven years (1973 Canadian investor) would cause irreparable financial or emotional harm.

For the future, a big question is whether rates of return will at least match those of the past, or more precisely which past - the boom after 1983 or the decade after 1973 when every portfolio and even T-Bills gained almost zero return in real terms. To see what difference a lower rate of return would make to end values, try a lower than historic growth percentage in a simple calculator such as GetSmarterAboutMoney's RRSP Savings Calculator.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

Risk Capacity: What is your capacity and does it match your tolerance?

Last week's post on risk tolerance mentioned that an investor's own financial situation can create more or less leeway to withstand the bad effects of poor investing results without permanent catastrophic harm, a feature we called risk capacity. We promised to look at what exists online to help an investor assess his/her own risk capacity, so here we go. The ultimate goal is to find the best investing strategy, specifically the mix of different types of investments, asset classes like cash / Treasury Bills, domestic or foreign equities, corporate or government bonds, REITs, or commodities, to combine into an asset allocation for the portfolio.

Risk Capacity - the key aspects

1. Time Horizon(s) - The longer before you need any or all of the money, the higher your risk capacity. Equities have historically on occasion gone through long periods of ten or fifteen years being underwater following market collapses. It is a big plus to not be obliged to cash in equities after a horrible down year such as the 40% 1973 dive of the TSX Composite and to be able to wait through the six year recovery period ( as bad as it was, the 2008 crash was only 34% and a mere two year recovery). Recognizing different time horizons for different goals e.g. house purchase in five years, university education in 18 years and retirement starting in 30 years pulls risk capacity in different directions. Tools or questionnaires that recognize such circumstances will produce a truer assessment. Some questionnaires ask too ambiguously about "when the money is needed back". It's not necessarily all or none - in retirement, one may turn an RRSP into a RRIF and withdraw small amounts to spend while continuing to seek some growth. 
2. Wealth - No doubt the world's richest investor Warren Buffett has little need to hold bonds or T-Bills to protect his modest lifestyle in case of a stock market decline. Conversely for someone with no other savings, a $1000 decline in a $10,000 portfolio verges on calamity. The more you have, the more you can put afford to put at stake, or as is often said, afford to lose. It's net worth, after deduction of debts, that is the relevant figure. Having to continue making payments on debt like a mortgage but not needing to count on the investment portfolio to provide cash is one reason we often hear the advice to always hold three to six months emergency cash reserves.
3. Other Income & Human capital - Economists call our lifetime earning power human capital. The higher your non-investment sources of income like salary the more likely it is there is a surplus or savings that buffers against any need to liquidate investments in a down market. Of course it is possible to use up any amount of income with too lavish a lifestyle, which is why some questionnaires go a step further and ask about your current savings rate. The other important aspect of the other income is how stable it is. A tenured professor has great job security while teachers and civil servants rate high as well but a commission salesperson or an hourly paid worker in a cyclical industry has a much less secure and reliable income stream. Professor and author Moshe Milevsky elaborates on the investing consequences in his book Are You a Stock or a Bond? (yes he does rate himself a bond) A secure income is equivalent to bond income while the less secure among us are the stocks. Given the huge proportion of almost everyone's personal lifetime income that comes from work earnings, factoring in your job to the decision of how to structure your investment portfolio, is a critical step. How much time you have left to earn makes a big difference too. Many questionnaires will therefore ask about your age and/or time before retirement. Some questionnaires will also use age to draw conclusions about time horizon though that is not the best way to do it. Salary is not the only possible source of other income. Canadians have access to Canada Pension Plan and Old Age Security payments after retirement. Some fortunate workers may be part of a solid defined benefit pension plan. Owning rental properties is yet another source. All these sources serve to increase the capacity to withstand bad effects when investment risk happens.

Figuring Out Your Own Risk Capacity
Questionnaires combine risk attitude and capacity - Unlike the questionnaires devoted only to risk attitude/tolerance, there are no questionnaires for risk capacity alone. Even the better questionnaires on risk capacity that we found all mix in risk attitude and some risk perception as well. It is therefore more difficult to discover any marked divergence between risk attitude and capacity, which is what we want to find out in order to think about and reconcile the two.

Index Fund Advisor Risk Capacity Survey - These US-based fund managers offer a short 5-question survey and a more complete 25-question long survey. It is well worth the extra few minutes answering the 25 question version. At the end, there is a question by question explanation of what your answer means, along with links to other parts of their website with in-depth explanations on the topic. An extract image of part of a sample output is below. The survey concludes with an overall stock vs bond recommended allocation. This is the best and most detailed questionnaire we found.

Mulberry Chartered Risk Profile and Capacity for Loss Questionnaire - This questionnaire is also only in pdf form so one must manually total the score for the 11 questions. Five questions address capacity and six risk attitude. It is meant for use by an advisor with a client so we have to do the usual DIY thing and be our own advisor to draw our own conclusions. Its unique feature is that it rates your capacity for loss separately, on a scale from Low to High.

BMO Insurance Investor Profile Questionnaire - Of the 11 questions, five relate to risk capacity, two to investing goals and the others to risk attitude. The questionnaire is only in pdf form so one must manually add up the score. The slots the investor into one of four types of portfolio - Conservative, Balanced, Growth or Aggressive, but no asset allocation recommendation is given. On this questionnaire we found that the risk capacity sub-total did not align with the risk attitude sub-total. The risk attitude questions seemed constructed in a way that caused our own answers to skew much higher than they should.

Vanguard Investor Questionnaire (USA) - Though Vanguard now has a Canadian arm, the website is not as extensive as the original one in the USA and it does not have a risk profile questionnaire. The US questionnaire consists of 11 questions only, half of which are devoted to risk attitude and the other half to risk capacity. The total score leads to one of nine possible recommended proportions of stocks and bonds, ranging from 100% stocks to 100% bonds. The scoring scheme puts enormous weight on the time left before beginning to withdraw income. There is no explanation of results.

Try all of them and look for consistent results - Rather than rely on any one of them, the thirty minutes or so that it will take to fill them all in lets us see how consistent the results are. Obviously, the more consistent the better since that means the various question wordings don't skew the answers and we can be more confident of being shown the right track.

Risk capacity should align with risk attitude - It's a bit more work to do since we must add up the sub-total score for the capacity questions alone but that gives us the ability to examine the all-important match-up between risk tolerance / attitude and capacity. Compare the capacity result with the tolerance answers from the FinaMetrica and Oxford questionnaires that we wrote about in last week's post. That will go a long ways towards reducing the divergence between what the questionnaires recommend and what investors end up doing.  It's an important potential failing of such questionnaires, as Preet Banerjee recently wrote in the Globe and Mail.

When this blogger did a personal comparison with last week's risk attitude questionnaire results, we generally did find convergence towards a 60% stock / 40% bond portfolio. But that is only our personal results for our own situation so every investor should do his/her own.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.

Risk Tolerance: Why and how to measure your own

It is standard best practice for a professional financial advisor to understand a client's risk tolerance. Since we, as DIY investors, have to be our own financial and investment advisor, that means we should be able to understand our own risk tolerance and apply the knowledge to achieve the same result. The desired end result is simply an investment portfolio that best suits our financial goals. A critical part of building an investment portfolio is to decide on an asset allocation, the mix of domestic and foreign stocks, bonds, GICs, cash (T-Bills or money market funds), real estate, commodities (gold or other) and risk tolerance plays an important role in that process. So how does risk tolerance fit in and contribute?

Risk tolerance vs Risk capacity vs Risk perception
A) Risk tolerance is an attitude, the preference a person has towards the balance between the chances of loss against potential gain. It is a psychological trait that is quite stable through a person's life, generally set by early adulthood, though it can change as a result of major life events, or evolve through the years, for example, as people get older their risk tolerance tends to decline. Everyone is different. Men tend to be more risk takers than women. Couples need to recognize that they are likely not to have the same attitude towards financial risk. Finding out differences and coming to an accommodation ahead of time within a couple will avoid strife down the road under the pressure of events. That's surely a big benefit on its own of obtaining a reliable measure of risk tolerance.

The people of some countries are more risk averse than others - apparently, Australians are more willing to take on financial risk than Americans who are more willing than the British, according to FinaMetrica in On the Stability of Risk Tolerance, which has collected hundreds of thousands of standardized surveys across these these countries. Another interesting point is that risk tolerance can differ markedly for a person towards physical, social, ethical, health and financial matters. The physical dare-devil might be a financial wimp, or vice versa.

The key result of matching risk tolerance with an eventual portfolio structure is that the investor should be comfortable with the portfolio. When the portfolio varies with market events there is less chance of a bad reaction when the portfolio behaves according to its matching risk level. The bad reaction can consist of emotional turmoil or it can consist of hasty ill-timed actions such as the notorious example of selling out after a temporary market plunge. However, as FinaMetrica note in their document on how to interpret the results of their risk tolerance survey, there is not an automatic consistency between the way someone reacts to an actual bad event, which they call "loss tolerance", and the risk he/she was willing to take.

B) Risk capacity measures the ability of a person to withstand negative outcomes before a person's standard of living is materially affected. It measures facts, most typically:

• Time horizon (the longer before you need income or the capital back the higher the risk capacity), 
• Wealth (the greater your assets, the more you can lose before it hurts)
• Other Income (again the higher this is, the greater the risk capacity)

The UK regulatory body, the Financial Services Authority, says in its publication Guidance Consultation Assessing Suitability, that it is important to measure risk tolerance separately from risk capacity. Otherwise it is impossible to know which aspect is being measured. Part of the job is to compare and reconcile risk tolerance and risk capacity. Lots of tolerance with low capacity is a big danger while low tolerance and high capacity means missed opportunity e.g. the opportunity to earn higher returns and a better lifestyle in retirement or a greater legacy to leave behind.

C) Risk perception is the conception a person has of the actual risk with regard to different types of investments. Perception can change a lot through time and it may change quickly in contrast to true risk tolerance. The tendency of investors' mood to track rising and falling equity indices is sometimes termed changing risk tolerance but the re-interpretation, in the face of the stability of real risk tolerance, is that such tracking is due to changing perception of market place risk. In rising markets, people begin to feel there is less risk. For an instructive discussion of the difference, see this post on leading retirement researcher Wade Pfau's blog. The antidote to mistaken ideas of risk for all investors:

• Investment Knowledge (being aware of past market history and how much and what kinds of risk there is in various asset classes, which this blog tries to address constantly and through specific posts such as this series of risk posts in July 2011)

Figuring Out Your Own Risk Tolerance

While we may have a general idea of our own financial risk tolerance, in order to compare it in any organized way with risk capacity and the portfolio options that are likely to produce required returns to meet financial goals, it is necessary to put numbers to risk tolerance. The way to do it is through a rated questionnaire. Taking into account the comments on best practices by the UK's Financial Services Authority, who examined and found wanting many questionnaires, there aren't many good choices. Two we found are:

• FinaMetrica - self-administered online version (evidently the same questions as the pricier version for use in volume by advisors), along with the user guide that shows the mapping to portfolio asset allocation ranges and a Risk and Return Guide for various portfolios oriented to Canadian investors that itself has links to the historical results for the various portfolios. The company actually has posted the questions for various countries as a downloadable pdf on this page but of course you don't get the scoring and interpreted results. There is a $45 charge to fill out the questionnaire and get the results, all in about 20 minutes, but it can be worth it to get the greater output detail compared to the free Oxford questionnaire. It has 25 questions. Part of the output report looks like this -

• Oxford Risk - developed by the University of Oxford, it is free here on the Standard Life website; it has 10 questions and takes only a couple of minutes to complete. The entire output looks like this - 

This blogger filled in both questionnaires (paying the $45 for the former) as honestly as possible for myself and found they gave the same results (a bit above the middle risk tolerance), which is encouragingly as it should be if they work properly. Other free online questionnaires we found did not give the same results. The questionnaires with erratic results  all seemed to violate the Financial Service Authority's best practices by confounding risk tolerance with capacity, or by being ambiguous asking several questions at once which left a feeling that no answer could be right for some questions. Such short and easy questionnaire tools would seem to be an obvious thing to do to make a significant step towards investing peace of mind, though not assured success, by proper alignment between one's inner attitudes and investing activity.

There are other questionnaires that measure risk capacity. Next week, we'll have a look at those to find the good ones.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons 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.