Volatility Part 2 – Enjoying the Merry-Go-Round Rather than Enduring the Roller Coaster
As I expressed in my last article, for retirees, volatility is a lot like that glamorous, thrill-seeking friend of your youth hated by parents everywhere: a lot of fun when things were going well, but prone to cause trouble, unreliable and, in the end, far more trouble than they were worth. In other words, the sort of thing we hopefully grow out of when we’re older and wiser.
In the world of retirement planning, unpredictability is like the common cold – unwanted, unpleasant and, although the symptoms can be managed, there is no real cure. Unless you’re unwilling to court other risks by investing exclusively in GICs or the like, volatility may be something you have to learn to tolerate, just like a runny nose. Any investment whose returns are not completely predictable, constant and guaranteed, requires accepting an element of unpredictability. Although this uncertainty can certainly work in our favour when the markets soar and our investments grow like a teenaged boy with an endless appetite, if we are already on track to live the retirement of our dreams before this unexpected bonanza, then these unexpected gains really won’t have benefited us too much. On the other hand, in order to get these large gains in value, it is usually necessary to court the risk of large losses instead. As I illustrated in my last article, unpredictable results that vary widely from year-to-year can turn your golden years into problem ones even if your so-called “average returns” are solid if the sequence of good years and bad years work against you, such as if you have some bad years early into retirement and are forced to liquidate savings for living expenses along the way before things pick up again.
Let’s look at this in a slightly different way and return to one of the basic lessons of mathematics – the shortest distance between two points is a straight line. This is also true for retirement planning. If you can use a straight line to illustrate your portfolio’s investment returns each year (which means earning exactly the same amount each year), it is pretty easy to predict the outcome if your other variables also toe the line. Unfortunately, life doesn’t work like that – instead of a constant 6 or 7% per year, returns will be inconsistent and the straight-line of our dreams will be replaced with something that may more closely resemble the random scratchings of a 3-year-old. On the other hand, although we may never be able to get that ruler-straight line, we may be able to organize our investments so that this line goes up and down in gentle hills and valleys, never straying more than a few percentages from the targeted average, rather than the wild peaks and troughs that indicate huge gains and losses that more closely resemble a mountain range. Put another way, we want to reduce the yearly, unpredictable fluctuates in portfolio returns or its volatility as much as possible, as the closer each year’s actual returns are to the portfolio’s average return, the less likely we will run out of money when we need it most. Thus, although the sequence of returns is vitally important, we can minimize their impact by reducing the overall volatility of our portfolios so that the bad years are hopefully never bad enough to scupper all our retirement plans, regardless of when they occur.
In order to illustrate this mathematically, I wish to borrow from some projections prepared by Newport Private Wealth¹, a firm that manages money for many high-net-worth clients across Canada and with which I have a referral arrangement. They tracked two investors, each with $2,000,000 portfolios and 7% average returns. Each withdrew $80,000 per year and experienced 2% fixed annual inflation and needed the money to last for 25 years. In fact, the only real difference between the two portfolios was the degree of volatility. One portfolio had 5% volatility (i.e. each year’s return was between 2% or 12% while still averaging 7% overall) while the other had 20% volatility (each year’s return was no less than -13% and no more than 27% while still averaging 7% over time). Newport then used something called a Monte Carlo Simulator to randomly vary investment results each year each portfolio within the ranges specified above within a normal probability distribution, while preserving an overall average return of 7% to see if each portfolio could pay out the full $80,000 plus inflation for 25 years. And they did this not once but 5,000 times. The results? The investor with the higher volatility had a 27% chance of running out of money while his more conservative counterpart reduced this risk to virtually 0%.
Think that 20% volatility is excessive? Think again. The TSX essentially had a volatility of over 22% over the last 5 years. While the investor with the 20% volatility would have also had scenarios among the 5,000 random projections that produced well more than the $80,000 plus inflation needed for retirement, (such as if there were several years of good returns early in retirement) you would need to ask yourself whether this extra gravy on top of a plate that is already full is also worth taking a 27% chance of running short of groceries.
Managing Volatility – What You Can Do
Assuming you have now decided to forsake the rollercoaster-like peaks and troughs of high volatility investments, how do you make this happen? If you wish to ride the low volatility merry-go-round, with only gentle rises and falls in investment returns, there are a number of steps you can take. Although there may be no single silver bullet, either working with the right investment professionals or taking some or all of the following steps yourself can take some of the guesswork out of retirement planning. Moreover, it is also important to realize that portfolios are not merely high or low volatility – there are an endless number of points between these two extremes. Thus, even if you are unable or unwilling to take all the steps listed below (as well as some of the others out there) to minimize volatility in your investing, you may at least want to turn down the volatility dial a little bit – as many investment professionals will tell you, it is actually possible to set up a portfolio with higher average returns while also taking some of the volatility risk off the table. Interested? Keep reading.
Controlling Correlation and Diversifying
One way of controlling overall portfolio volatility is owning different investment classes that don’t react the same way when experiencing the same market conditions. In other words, you are looking for investments that may actually rise, or at least hold their own, if all your bank stocks tumble so that the net effect to your portfolio isn’t as dire. Expressing this in investment-speak, if two asset classes are “positively correlated”, it means that they respond similarly to changes in the stock market. If their degree of correlation is 1.0, it means that they respond exactly the same way. If they move exactly opposite to each other, their correlation is -1.0. If their correlation is 0.0, however, there is no connection at all to their annual investment returns. Thus, if you want to protect yourself from unnecessary ups and down, you generally don’t want a lot of assets classes that have a strong positive correlation. On the other hand, a strong negative correlation is a wonderful thing while owning classes or sectors that are uncorrelated is also very useful.
Many investors believe that they are properly diversified by owning a mix of stocks and bonds. Unfortunately, according to another Newport study², people aren’t as protected as they may think. In fact, an 80% U.S. equity and U.S. bond 20% bond portfolio had a 1.00 correlation over essentially a 10-year period ending in December, 2015, while a 50/50 mix generated a strong .97 correlation and even a 20% equity, 80% bond portfolio had .64 correlation. Thus, even if you held mostly bonds (which I do not generally recommend), your bonds wouldn’t have helped you over that ten-year period if the market tanked.
Accordingly, the first step is ensuring that you diversify outside of just one country. For Canadians, this is also important because we don’t have a lot of Canadian options for some of the other different investment sectors, such as high tech and pharmaceuticals, in the first place. Secondly, I also suggest looking outside the world of publicly traded-stocks and bonds, as they certainly aren’t the only game in town, even if the banks and their mutual funds may lead you to believe otherwise. Some additional options to investigate are private infrastructure projects, private debt, investing in private companies, owning private real estate funds (as well as potentially your own investment properties in some cases). Quite simply, there are a lot of other ways of investing your money than through public stocks or bonds. By doing so, you can lower your portfolio’s overall volatility because of a weaker correlation between these alternative investments and public ones, in addition to the fact that many private investments have a far lower overall volatility in the first place. In addition to investing through an exempt market advisor, such as through Klint Rodgers of Pinnacle Exempt Market Dealers (another referral partner of mine), clients can often also get exposure to alternative investments through private wealth management companies such as Newport.
There are other risks for different types of investments – again, there is no silver bullet out there – but by minimizing your risk to any one type of risk, even if it means taking on some different types of risks with part of your portfolio, you are still increasing the chances of overall success, provided you diversify intelligently. Although diversification can be a lifeline for your retirement dreams should the public markets crash, it only works if your alternative investment choices are sound ones. Although there are many private market investments that I love, there are also others that I wouldn’t touch with a ten-foot pole.
Be a Beta Blocker
Besides constructing a public equity stock portfolio that includes a diverse mix of investments from different sectors and parts of the world, the volatility-adverse investor may also wish to narrow his stock picks to those boring, solid, mature businesses that have a strong record of consistent earnings. Although those companies won’t do as well during the good times, they won’t suffer as much when the sky is grey, which is far more important when investing during retirement. In other words, blue chip stocks are probably a better choice than shares in that junior gold stock you heard about in the golf course lounge. They even have a stat that tracks how much a stock moves up and down relative to the stock market as a whole, which you may wish to investigate called “beta.”
A stock with a beta of 1.0 moves up and down with the same volatility of the stock market to which it belongs, while one with a beta of 2.0 moves up or down twice as much as the stock market. On the other hand, a stock with a beta of only .5 would only suffer 50% of a market’s losses but would only reap 50% of its gains. For example, if the market went up by 10% in one year, a 1.0 beta stock would generally also increase in value by 10%, a 2.0 beta stock would grow by 20% and a .5 beta investment would increase by 5%.
It is also possible to have negative beta stocks, or those who move in opposite directions to the market as a whole. Using the previous example of a year when the market grew by 10%, a -1.0 beta stock would shrink by 10%, a -2.0 beta stock would decrease by 20% and a -.5% beta pick would decrease by 5%. Accordingly, building on the previous section and the goal of setting up a portfolio that is properly diversified, using both low beta stocks, as well including some that do well when the market as a whole suffers both make sense. Unfortunately, as investment types like to say, past results do not guarantee future performance. This also applies to beta. Stocks with a low beta to date may slowly grow riskier or those that were high beta in their start-up phase may become a lot safer once they have both feet firmly planted. This both means that using beta to set up a portfolio is more of a guide than a guarantee and that it is necessary to continue to track a stock’s beta over time.
Show Me The Money
One of my favourite ways of minimizing volatility is to own investments that pay me as I go. I suggest this for several reasons. First, during retirement, the more income you receive from your portfolio each year, the less capital you will need to liquidate in order to fund your lifestyle. As one of the biggest investment risks during retirement is being forced to “sell low” in order to pay for that week’s groceries, more income means more time for the rest of your portfolio to bounce back during those inevitable recessions.
Secondly, I’ve found that more income means less worry for most clients. The more income they generate, the less they worry about market ups and downs, as growth isn’t as important. This is also one of the other reasons I love private market investments – they can often pay out substantially more than most public market investments.
As an aside, although exempt market exemptions may be considered high risk – and this is certainly true in some cases – I have a hard time accepting that such a diverse array of investment offerings all have exactly the same risk profile. I prefer to think about private offerings in the same way as I view public market investing – each needs to be judged on its own merits. Although there are some that I would never touch, I am far more comfortable with many private market investments offering regular, significant income payments to investors with a sound business plan, a sterling track record that has been vetted by outsiders and which is structured to align its interests with its investors than with many public stocks.
Returning to the public market, those same blue chip stocks discussed previously also often pay out handsome dividend streams, which can be tax-advantaged for investors in the right tax brackets who aren’t worried about OAS clawback. Finally, if you haven’t heard of MICs (Mortgage Investment Corporations) and REITs (Real Estate Income Trusts), then I suggest taking the time to learn more about both. These investments can generally pay out significantly higher yields than many dividend payers and may provide diversity. Both are real estate plays. They can be investments that trade on the public market or private investments. They may be Canadian investments but it is also possible to own US real estate in Canadian REITs as well. Moreover, REIT also vary according to the type of real estate owned in addition to geographically. For example, there are REITs that invest in: apartment buildings, office buildings, industrial buildings, retail properties and retirement homes. As an added bonus, many REITs are able to pay out some or all of their distributions as “return of capital”, which is tax-free until you’ve received all of your original investment back, although it will probably mean paying more capital gains tax later when you sell your REIT.
I also like using Options as a way of both protecting portfolios from sudden crashes in value and to also generate extra income during times of higher volatility. Although many people seem to automatically assume that Options mean taking on higher risk and volatility, this is not true. Although there are some pretty high risk Options strategies circulating through the investment world, Options can also be used to take volatility off the table. I particularly like using “covered calls” (as I have written about previously) which involves selling some of the potential upside on stocks you already own over a stated period, in exchange for cash on the barrel now. Although you may miss out on some of the run ups in value in the good times, you increase your cash flow, which decreases your overall volatility and the chances of having to sell capital during a down market. The amount you can receive for selling some of the upside varies according to market conditions. These payments, called “Options Premiums”, are actually the highest during periods of high volatility. If you want to know more about this, I suggest talking to Thomas Tsiaras of Industrial Alliance Securities Inc.in Vancouver, who does this for me and some of my clients, as most brokers do not offer their clients Options strategies.
On a final note, Options can also reduce volatility by minimizing your downside if you want to purchase this protection on all or some of your portfolio. This may be particularly valuable when investing in more volatile stocks or when you are worried about the market being overvalued but not wanting to convert your portfolio to cash in case you are wrong. Buying Call Options provides you with the right to sell stocks at a set price regardless of whether the actual trading price at that time is less than this value, thus capping how much you can lose on that stock since you can always sell at the call price if things are dire
Ultimately, while I believe that yield is your friend, it is only part of the mix when making investment decisions. While there are investments with significant yields that may be ideal for the right investor, a high yield can also be a potential warning sign in other instances. In other words, there might be a reason why a publicly traded stock is paying 10% per year, such as a recent fall in fortunes or the expectation that it will have to cut payments, or why a private market investment pays out so much.
Although volatility can make the good times better, it also means increasing the chances of life going horribly wrong. Although many of us focus solely on average rates of return, this rather misleading statistic paints a far from complete picture as I hope I hammered home in my last missive. In order to make an informed decision, it is essential to know the risks you need to take in order to get this return and how this may affect your retirement dreams. If your goal is to live, enjoy a secure, stress-free retirement that provides you with the best chance of success, then taking steps to minimize volatility should be a key part of this plan. The retirement you save just may be your own.
¹. Newport Private Wealth ( What the Smart Money Knows whitepaper, January 2016.)
². Newport Private Wealth ( What the Smart Money Knows presentation, January,2016).