This is a critical question to answer when you sit down with your Investment Counsellor to construct an appropriate asset allocation for your portfolio. It is also a timely question in the current capital market environment where stock prices have continued to be bid up, interest rates have been stagnant or lowered, and value has become increasingly hard to find. There are, of course, other essential considerations – investment time horizon and annual spending requirements, to name a couple – but if we don’t properly assess your tolerance, significant market volatility can set the relationship – and your portfolio – off to a rocky start.
Let’s begin with some clarity on volatility, and differentiate it from risk. Joe Rooney outlined in his post “What Keeps Burgundy Up at Night?” that volatility can be defined as a month-to-month or quarter-to-quarter focus on relative returns versus a benchmark, whereas, from our perspective, risk is a combination of many factors that ultimately result in permanent loss of capital. While our Portfolio Managers view downside volatility as an opportunity to enter into a stock position with a margin of safety, it can be an unpleasant experience for our clients. Risk, on the other hand, is something that our Portfolio Managers diligently work to avoid.
When discussed in the abstract, the question of “How do you feel about volatility?” doesn’t carry much weight. General answers probably range from “ok” to “not great.” Those vague and abbreviated responses may translate into starting asset allocations of 80% Equity / 20% Fixed Income for “ok” and 60% Equity / 40% Fixed Income for “not great,” but they could also mean an entirely different set of numbers for someone else. Numbers that we can all relate to are cold hard dollars.
Using $1,000,000 as a round initial investment, how would you feel if, within the first year, your initial $1,000,000 investment dropped to $800,000? This scenario is not an exaggeration merely for the sake of illustration; when pressed, I’m sure we can all recall the capital market chaos of 2008 when losses were swift and painful. This period in time is worth revisiting to help shape a more accurate response.
Below, I have outlined how your theoretical $1,000,000 portfolio would have behaved in 2008 if it was invested in a combination of the MSCI World Index (a global equity benchmark) and FTSE TMX Canada Universe Bond Index (a Canadian government and corporate bonds benchmark). The range of asset allocations shows the unrealized dollar losses for each scenario.
If your response to the question was “ok,” or an 80% Equity / 20% Fixed Income portfolio, you would have experienced an unrealized loss of nearly C$200,000. If you answered “not great,” or a 60% Equity / 40% Fixed Income split, you would have experienced an unrealized loss of approximately C$130,000.
While 2008 was of extreme magnitude, it cannot be conclusively said that the events leading up to that financial tsunami will remain in the past. These numbers are not for the faint of heart, but they do help to demonstrate how a true understanding of your tolerance for volatility can play a vital role in the conversation with your Investment Counsellor – and with yourself.