Hi everyone!
Welcome to part 2 of the Q&A! To recap, on Instagram– I shared that I would have a Chartered Financial Analyst (CFA) charterholder answer your investing questions just in time for the new year and TFSA limits refresh. With that, here is the Q&A below.
Before we get into the Q&A, I’d like to state that the answers are just my opinion. It should not be deemed actionable advice without your due diligence. The answers are rather broad observations and insights I’ve picked up over the years.
From those questions, there were three key themes: how much should they save/need to retire, how much risk can they assume, and asset classes (real estate vs. stocks vs. ETFs, etc.) This post answers the questions around risk tolerance.
Part 2: Risk Tolerance and Risk Management
As someone who is in their early thirties and doesn’t plan to withdraw funds from their RRSP until retirement – how much risk should I take on?
This question touches on a critical aspect of investment management: risk tolerance.
Risk tolerance is a very individually specific yet critical aspect of investment management. In saying that, your current age and tax consequences should be just part of the overall risk tolerance picture. It’s near impossible for anyone to assess your risk tolerance without knowing much more about you.
To answer your question, think about these two drivers of your overall risk tolerance: ability and willingness. Ability is typically an objective measure, and willingness generally is a subjective measure. When you think about your ability to bear risk, think about things like your ability to save regularly, the length of time you are planning to stay invested and needs to withdraw money, and whether or not you have a pension in retirement.
There are other aspects to your ability to bear risk; these are some thought starters. When you think about your willingness to take risks, think about your attitude and behaviours towards your money. Do you dislike losses more than you like gains (loss averse)?
We know hindsight is 20/20, will this attitude creep into your investing decisions? Your willingness is often not something you would know yourself – it’s another area where speaking to a professional will help you significantly.
As a Canadian, if my portfolio is made up entirely of USD stocks/ETFs – what are the risks?
This is a common question that I get asked by clients, friends, and family. As the question refers to several essential terms, it would be good to dissect the question into parts to be clear on each part of the question, as risk exists in 1) the investment portfolios, 2) stocks and ETFs, 3) USD investments. Once we cover these, it’s important to reassess whether you can tolerate these risks based on your investor profile.
Portfolio Risk
Let’s start with ‘portfolios.’ A portfolio is a basket of investments, a combination of assets that aim to achieve your financial objectives while minimizing the risks that your investments are exposed to. At the portfolio level, the risk is called Portfolio Risk, which is the risk your portfolio fails to achieve your goals, or even worse, generate a negative return. Investors typically address and mitigate this risk through proper diversification.
Sector and Company Risk
When you invest in individual stocks (aka stock picking), you are also exposed to overall market risk, sector risk, and company risk. These are relatively self-explanatory, but the market risk is the overall risk an economy faces (like the worldwide shutdown in March/April 2020). Sector risk is the risk a business area/focus faces from operating within that area (like oil companies when no one needed oil earlier this year, and the whole sector suffered). Company risk is the risk specific to that company (like SNC-Lavalin when it was caught up with the Canadian Federal Government drama and saw its share price and investor confidence wipe about 15 years of gains). This approach to building your portfolio is generally for the more advanced do-it-yourself investing crowd.
That is not to say that you can’t achieve proper diversification from stock picking – it’s just not for everyone due to its costs to buy/sell, research, analyze, and stay on top of the news. However, cheap and efficient diversification can be achieved through several ways, which I won’t get into fully here.
However, ETFs are an excellent way for beginner investors to learn about risk and risk management. When it comes to its risk when you buy ETFs, you are exposed to market risk (i.e. volatility), the risk of over-diversification (owning too many ETFs), and sector concentration risks (i.e. too many stocks in cannabis in a cannabis ETF). Let me be clear, though, ETFs are a great way to diversify your portfolio, especially if you have a relatively small portfolio. However, owning more than 2 or 3 exposes you to over-diversification.
There is plenty of evidence that shows owning around 20 individual stocks is the most efficient way of diversifying your portfolio. Owning more than 20-25 stocks gives you little benefit in terms of diversification. Given that ETFs typically hold 30-50 stocks at any time, owning more than 2 or 3 ETFs gives you more diversification than you need to pay for via fees relative to potential returns.
When you invest in USD stocks or ETFs, the main additional risks you are exposed to are political risk (will the American president enact a policy that limits growth?), and currency risk (how much is my CAD worth today, vs. when I would like to sell?)
As an example, think about American policies against the Keystone XL pipeline. This is a political policy that will inhibit the parent company’s growth and might lower the value of the CAD as we can no longer generate income from selling a natural resource.
Currency Risk
Currency risk is the other big one. Let’s use an easy and hypothetical example to highlight the risk. If you purchase 1 share of ABC co. at $100USD when the exchange rate is at $0.70USD/CAD, you paid $143CAD. If the stock goes up 10%, that’s $110USD. If, by chance, the CAD strengthens against the USD, which we saw in 2020, and the rate is now $0.75USD/CAD, your share is now $147CAD. So while the stock went up 10%, your return is only 2.8% due to currency risk.
So if you take all of these risks into account, what risks are you both able and willing to tolerate? How is your portfolio built to address these risks? What do you believe are the chances of some of these example events happening over time, and how tolerable are they to you?
About the author:
Trevor Lee, MSc, CFA, is a registered Portfolio Manager at a discretionary portfolio management firm based in Vancouver, BC. He focuses on building high-quality investment portfolios for investors of all sizes.
Disclaimer:
The content in this post is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained in this post constitutes a solicitation, recommendation, endorsement, or offer by myself, my firm, or any third party service provider to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.
