As many of our regular followers know, a key tenet in how we manage individuals and families is by trying to minimize emotion in the construction and maintenance of a portfolio. Now, let me be clear. There is a ton of emotion wrapped up one’s wealth. The capital saved and grown over the years came from hard work, sacrifices and tough choices. To tell someone not to worry about their financial nest egg is simply wrong. The degree of “worry” plays an important role in determining risk tolerance which itself represents one of the three pillars that constitute and investment strategy – ability to take risk, willingness to take risk and the need for risk.

 

When we spend time with someone in the examination of these three factors, we always prioritize the willingness result and for good reason. While it may seem correct to tell someone with a high and stable income and/or massive financial resources that they can take a higher level of risk because a loss may not materially impact them, this ignores the price tag of worry.

 

An older gentleman called me many years ago for my thoughts on how much risk he should have. He was fairly well off and in his 70s. He didn’t need the money in his portfolio and was being advised to have a higher allocation to stocks than he currently did.  I asked him if he wouldn’t mind telling me what his current exposure was and he said it was about 20%. I then asked him what his current state of mind was regarding his portfolio and he said he worried every night. Clearly, this portfolio strategy was on the conservative end of the spectrum and it might seem intuitive that he take more risk. However, if he was already worried with 20% exposure to stocks, how would he feel with 30%, 40% or more? Answer – not too good.

 

 

I believe that this year is going to be notable in discussions of investor psychology and thoughts around risk tolerance because portfolio weakness has not just come from equities, but from the bond market as well. In fact, the Canadian universe bond index has delivered a negative 12.8% return since the start of the year, compared 7.7% for the TSX. Indeed, this year has been unprecedented. For Canadians, the tightening in monetary policy this year is the most aggressive we have seen from the Bank of Canada since 2005-07.  Back then, the overnight rate target at the Bank rose from 2.5% to 4.5%.  While the increase of two percentage points was still smaller than the 3% hike we have seen this year, it was still a sizable move.

 

Even still, the Canadian bond market saw a net positive total return of 1.6% from August 2005 to July 2007. The TSX delivered more than a 18% total return over the same period, although the index would give all that back over the remainder of 2007. That would prove to be the appetizer for what would happen from June 2008 to March 2009, when the TSX suffered close to a 50% decline. This was partially offset by a 5% total return in the Canadian bond market. 

 

 

The financial crisis had a pronounced effect on investor behaviour. There were essentially three types of investors through that tumultuous 2008-09 period. The main camp had asset allocation strategies that were aligned to their risk tolerance and they simply waited out the storm. Another group endured a ton of anxiety over the ensuing months, only to realize at the end of it that they did not have an aligned strategy to begin with.  These individuals sold in the final weeks and months of the bear market, crystallizing their losses and then waiting months, if not years, to re-enter the market.

 

There was another group, however, that realized earlier in the process that they either didn’t have the right portfolio strategy that matched their risk tolerance, or that that their risk tolerance was altered by the events of the day, such that the strategy had to change. I believe we are witnessing something similar today. As before, the majority of investors appear to have properly aligned strategies and are weathering the volatility in markets this year. Sadly, there are probably a number of individuals out there that got carried away with the rally in markets post-pandemic and adopted overly aggressive portfolio positions. I have come across some though that are recognizing that they need to adjust their risk levels lower.

 

Regulations require that risk monitoring and evaluation be an ongoing process, though this only applies to investors that are under the care of an advisor. For DIYers, that risk reflection process is harder, but it no less critical. I have always told people that changes in risk should not be a high-frequency occurrence, but one based on careful consideration of the three pillars of risk mentioned earlier. Some people have chosen to retire earlier because of the pandemic. How does that decision affect their financial viability over the remainder of their life? Does this decision require an adjustment to the portfolio strategy?  Some are still years away from retirement, but may be finding that their risk tolerance has shifted. Others may be in a situation where neither their ability or willingness to take risk have changed, but that they see an opportunity to shift into higher-yielding fixed income securities and away from stocks.

 

Whatever the situation you find yourself in, it is important to make the necessary changes sooner than later. Ally and I are still of the opinion that further aggressive tightening by the Bank of Canada and the Federal Reserve is not necessarily a given, especially if economic signals over the coming weeks come in well below market expectations. If that is not the case, then the “threats” of further tightening will likely become reality and that means the pressures on the North American economy will intensify. To the extent that this looks like a major recessionary headwind, the appropriate response will be to de-risk from whatever strategic equity allocation we have. This morning’s employment reports for both Canada and the US, while not stellar, did not indicate the type of slowdown that would convince policy makers to pair rate hikes.

 

 

The positive aspect is that investors have choices of where to deploy capital in the event that equity exposure is taken down. Cash, which has paid next to nothing for years, now offers a return that isn’t too shabby for a short-term parking spot. Government and investment grade corporate bonds are similarly good opportunities, especially in light of the trouncing they have taken this year. If a significant economic downdraft takes place, central banks will be forced to cut rates and this will likely lead to capital appreciation in the bond space.

 

Have a great Thanksgiving weekend everyone

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.