Take money off the table

What questions do we dislike hearing from our clients?

In this week’s blog, we’re going for something a little lighter…irritating questions!

We get some pretty wild questions as financial advisors. Investing in the stock market can be scary and confusing to some and as a result, some odd questions come up from time to time. We’re not saying that these are ​bad q​uestions but it’s safe to say that if you ask your financial advisor one of these questions, you may see your advisor’s blood pressure rise a little bit…

Enjoy!

Question #1: “Should I take some money off the table and run?”

It might surprise you to hear that this in one of the most hated questions I receive.

It implies that I gamble for a living and that I give gambling advice to clients. And it suggests that all of us are just playing one big game of chance.

Here are a few other questions that get my goat: ​“How should we play this market? Why don’t we sell my money and let the house’s money ride? Why are we having such bad luck?”.

If you have ever played a casino game, you know that the odds are stacked in favour of the house. Hence, the longer you play, the higher the likelihood that you will lose money—and possibly every penny of it.

However, if you invest in (not gamble on) the S&P/TSX Composite Index, the longer you stay in, the lower the chance you will lose money (very close to 0% over 30 years).

I consider myself a long-term investor. I do not play casino games, because odds are I will lose money. I hate losing money. So instead, I invest where the numbers are in my favour, and I invest heavily.

Some investors don’t consider investing as gambling or speculating but still wonder if they should sell during market extremes. If you have found yourself in this camp lately, let me clarify the question you are asking—and a few others that often come up.

Question 2: “Can I time the market?”

The short answer: probably not.

Timing the market involves two important decisions:

1. When to sell.
2. When to buy back.

Personally, I find it difficult (if not nearly impossible) to make the sell and buy decision correctly over the long term—without an investment model. For most DIY investors, timing the market will likely fail.

Five years ago, I conducted a study on this timing question, and my research showed that the market DOES provide clues when it’s about to change directions. Based on that data, I built a model called the Smart Fixed Income​.

In simple terms, the model flashes a buy when the market trend is positive and a sell when the trend changes downward.

The research shows very promising performance numbers over the long term. However, the model is not perfect and occasionally the signals are wrong, or we buy too early or sell too late.

In short, if you use a successfully back-tested model, you may garner a benefit over the long term by timing the market. However, if you follow your gut—or, worse, the media—the chances of profiting from market timing are very low to zero.

Question 3: “Can I sell-off my investments to buy stuff?”

During appreciating markets, it’s common to feel motivated to sell some of your holding and use the proceeds to purchase stuff that you want (not necessarily need).

Perhaps the urge is to buy a new car, a bigger house, some fancy designer accessories, or something else…

When clients call to discuss buying stuff, I often refer them to the book ​The Millionaire Next Door​ by Dr. Thomas Stanley. The author explains that some people look rich because they drive around in expensive cars but, in reality, may have very little in the way of assets.

He calls this group “income statement rich.” I​ bet you know a few people like this…

Stanley suggests that investors work on becoming “balance sheet rich.” That is, owning assets that appreciate over time, like stocks, real estate, art, and so on. This type of wealth doesn’t display itself in the way you dress or the car you drive but ultimately results in more wealth, long-term.

In short, don’t let income statement riches dictate your purchases. Concentrate on the balance sheet.

Question 4: “Do I have enough money?”

This question is usually asked by a person who has saved and invested for many decades and feels that they may have enough money to satisfy their lifelong cashflow needs.

I answer this question by projecting the minimum growth rate that is required to generate the desired cashflow.

For example:

If I run different stress tests on the client’s investment portfolio and arrive at a required return of 2% or less, I suggest the client reduce their risk by increasing their allocation of guaranteed investments like GICs.

This investor has “enough” and doesn’t need to assume risk in order to obtain higher returns. They can make ends meet by earning the interest rates payable on guaranteed investments like GICs.

If you have reached your investment goal, stop playing ​the game​ (sorry, I couldn’t resist just one misplaced gambling reference). What I mean is, you can stop investing as you have been. Focus on guaranteed investments and avoid everything else.

Question 5: “Has my risk profile decreased/increased?”

This is a common question for investors. I even asked this question to myself this year!

During market corrections such as in March 2020, I asked myself if I would be better off reducing my risk level. And when the markets began improving (April to August 2020), I wondered if I should increase my risk profile and take advantage of the upside.

Does this line of questioning sound familiar? If it does, keep reading.

Changing the asset allocation of a portfolio during market extremes is usually not a good a plan. But there are three questions I ask before changing a client’s asset allocation:

a) Has your risk tolerance changed?

At the beginning of all investment and financial planning engagements, we ask questions to help determine the client’s investment risk tolerance. Basically, we try to estimate the maximum amount of risk (i.e. stocks) the client will tolerate, which basically means that any additional risk beyond this level would tempt the client to sell during a correction.

For example, assume in a bear market the maximum stock drawdown is -35% and during this period, bonds increase by 5%. Also assume, to start, an asset allocation of 80% stocks and 20% bonds. Different allocations of stocks and bonds vary the impact of the downturn.

Have a look at this:

*Maximum drawdown = (-35%*stock percentage) + (5%*bond percentage)

Can you accept the loss at an 80/20 allocation and continue to believe that the market will recover (as it has done in the past)? Or would you be motivated to sell and protect whatever you can?

If you chose the latter, I suggest your asset allocation is too aggressive and the risk profile should be lowered.

Now, look at an asset allocation of 50% stocks and 50% bonds and maintain the other assumptions. Here, the maximum drawdown is reduced to -15%.

Can you mentally withstand a drawdown of approximately 15% without losing sleep or selling?

In short, the ideal is to keep adjusting the asset allocation until arriving at a percentage of bonds and stocks that allows you to maintain your position during the worst market corrections.

If stress testing is performed at the beginning of the engagement, investors generally don’t question their asset allocation during market extremes. However, if they didn’t consider worst-case scenarios when selecting an asset allocation, then investors may have assumed an overly aggressive portfolio and an asset allocation adjustment would be necessary.

b) Has your risk capacity changed?

During a financial planning review, we evaluate all sources of income, including “potential” sources such as inheritances, employer pension plans, or divorce settlements.

For example, assume a client expects a sizable inheritance within 10 years. We include the inheritance in their retirement projections in year 10, and we emphasize equities over bonds because the inheritance covers 70%+ of their cashflow requirements in retirement.

Then, assume that in year three, the investor learns they will no longer be receiving the inheritance because of family issues. Now, they must rely on their own investment portfolio to cover 100% of their retirement cashflow needs. They can no longer accept large swings in their portfolio because they may need to sell some of it, even during market downturns.

This is a good example of a life event that reduces an investor’s capacity to accept market volatility, hence requiring an asset allocation adjustment.

c) Has your risk willingness changed?

Generally, the younger the investor, the greater their willingness to accept volatility/risk. Younger investors have longer time frames to recover from market corrections, so they are more willing to accept market downturns.

However, I know many young clients who have a very low risk toleration (I call them scaredy cat investors). I also know of older investors who are very willing to accept market risk regardless of their age (I call them honey badger investors—have you seen these fearless creatures in action?).

Again, when the client’s willingness to accept risk is discussed in advance, I generally find that they don’t question their asset allocation during market extremes.

So, before changing your asset allocation, ask yourself if any of these have changed since drafting your Investment Policy Statement (IPS)​: risk tolerance, capacity to assume risk, or willingness to accept risk.

More often than not, a client answers no and leaves the asset allocation as outlined in their IPS. If nothing has changed in their investor profile and a proper stress test was performed before investing in the first place, then there is no reason to change the asset allocation (especially during a market correction).

In some cases, the client answers yes to one or more of the questions. Usually, they lower their risk tolerance.

A change in risk tolerance during a market correction is expected with less experienced investors. When we talk about it, I ask if the investor has tested their asset allocation decision during a real market correction. If they have little experience with market corrections, I usually err on the side of caution and recommend a lower equity exposure than otherwise recommended.

In conclusion, consider what you are actually asking when you are tempted to “take money off the table.” Ask yourself why you feel compelled to sell some or all of your equities. And keep asking questions until you arrive at the real reason you want to sell. This process should stop you from selling because of media headlines or emotional anxiety and limit your asset allocation changes to situations when your investor profile changes.

Never Retire Profile

Louise Glück

If you’re not a literary type, you may never have heard of Louise Glück—but the whole world knows who she is now. Glück is this year’s recipient of the Nobel Prize in Literature, selected “for her unmistakable poetic voice that with austere beauty makes individual existence universal.” The 77-year-old American poet and essayist has won dozens of prizes, including a Pulitzer, and was Poet Laureate of the United States from 2003-2004. At the Nobel announcement this year, Glück’s poetic style was described as “candid and uncompromising” as well as “full of humour and biting wit.” While she studied at Sarah Lawrence College and Columbia University in the 1960s, which is also when she began writing, Glück did not earn a degree and supported herself by working as a secretary. Now a professor and writer in residence at Yale University, Glück has no plans to put the pen down. If you feel like dipping into this poet’s body of work, perhaps try her 1992 award-winning collection, ​The Wild Iris.​

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