Risk has always been part of the investment landscape, whether it’s defined as volatility, erosion of purchasing power or permanent loss of capital.
Risk tolerance varies widely among individuals, and financial advisors find that many clients can’t estimate their actual ability to handle risk until faced with a sharp drop in the value of their holdings. Appetite for risk can also change with a client’s financial circumstances, age and investment experience, with many becoming more risk averse as they approach retirement.
In the current environment, low interest rates are creating challenges for investors. Traditional fixed-income investments such as guaranteed investment certificates (GICs) and government bonds pay paltry rates of interest that have led many investors to seek income in securities higher up on the risk/return spectrum, such as corporate bonds, dividend-paying common stocks and preferred shares.
At the same time, equities valuations are at high levels in many developed markets, and although stocks have traditionally offered superior returns to other asset classes in the long term, they’re characterized by occasional and sometimes severe corrections.
Excessive volatility often causes investors to panic and bail out at the wrong time, and that means they don’t participate in the upside when markets recover.
“Extensive diversification across many asset classes, along with sufficient steady cash flow, encourages investors to stay the course and keep their money working for them,” says John Nicola, chairman and CEO of Vancouver-based Nicola Wealth Management Ltd.
On the fixed-income side, if interest rates continue to notch up, the value of outstanding bonds issued at relatively lower rates could decline. Many income-oriented investors would be best served at this point in the cycle by focusing on short-term bonds or floating-rate securities, as they’re more flexible than long-term bonds that don’t raise their interest rates along with the market.
High-interest savings accounts offered by major banks as well as non-traditional financial institutions can also be a viable alternative for parking money until interest rates stabilize.
For investors seeking a guaranteed rate of interest, GICs present an option. In addition to the garden-variety GIC, there’s a wide assortment of equities-linked offerings with returns tied to various Canadian and international stock market indices. An equities-linked GIC offers a combination of a principal guarantee with the upside potential of stock exposure. The catch, however, is that equities-linked GICs usually don’t offer the full return achieved by the underlying index or portfolio, so it’s important to read the fine print.
Advisors looking to smooth out client returns in volatile times can also add some exposure to insurance products that come with a guarantee, such as income annuities, segregated funds and products with a guaranteed minimum withdrawal benefit. These options can offer either protection on asset values or a regular income stream guaranteed for the client’s life. Depending on the bells and whistles, they can also offer some growth or inflation protection, but there are costs and restrictions. For investors who can’t tolerate any kind of fluctuation in their holdings, the cost of those guarantees can be worth it.
“It’s important to diversify across strategies with different risk factors,” says Sam Febbraro, executive vice president of advisor services at Investment Planning Counsel Inc. in Mississauga, Ont. “Advisors who set the appropriate strategy and asset mix up front should have no problem talking to clients about rebalancing and staying true to objectives. The planning process is critical. Diversification is not just about the equities and fixed-income markets, it may also include insurance and risk-management strategies.”
The unpredictability of investment returns that non-guaranteed assets generate is one of the biggest risks retirees face, particularly when the number of years they may need to live off their savings is increasing with longer life expectancies. With an annuity, an insurance product purchased with a lump sum that produces tax-efficient income based partially on return of capital, the longevity risk of any one individual is passed on to the insurance company.
Many advisors recommend that some clients — particularly those lacking a defined-benefit pension — purchase an income annuity that will guarantee enough to cover their bare-bones living costs for life, whether the client dies next year or lives for another 50 years. The disadvantages include the client not being able to get savings back, the loss of assets available for heirs, and the erosion of buying power if the annuity’s income-stream has no potential for growth.
This is the first article in a three-part series on managing risk.
Up next: Using alternative investment strategies to minimize risk.