Safest looking route not always best

(September 16, 2004) Investors can be a skittish lot, shying away from the investments they really need as an over-reaction to market fluctuations. Many felt like they fell off a mountain in 2000-2001 and are still not willing to give stocks a chance, even though all evidence points to equities as the surest road to a sound retirement.

In a 2004 presentation at that year’s AIM Trimark’s PD Network Live in Toronto, Eric Cockshutt, vice-president, practice management, likened financial planning to climbing Mount Everest. It’s a difficult uphill battle that requires resilience and more importantly, a skilled guide.

When the climber reaches the summit, he can feel a sense of accomplishing the near-impossible as he surveys the world laid out before him. To the Sherpa, however, it’s just another trip up the mountain. His satisfaction comes from seeing clients reach their goals.

“In many ways I think your life as a financial advisor mirrors that of the Sherpa,” says Cockshutt. “The client ultimately gets the glory of achieving their goals, but you’re there every step of the way guiding, providing encouragement and wise counsel.”

The guide on either of these journeys — either the Sherpa or the financial advisor — knows they will be littered with obstacles. Any attempt to charge straight up the mountain in as little time as possible will undoubtedly result in catastrophe.

It is not only the advisor’s role to plan the route to, say, retirement, but to also make sure their clients understand they are facing a bumpy road.

Framing perceptions

Cockshutt says it is important to provide the context of the problem before setting about solving it. Clients will be far more comfortable with the solution you present if they are fully informed about the challenges they face.

“We’re going to tell our clients upfront some of the things they need to overcome before we even start solving problems for them,” he says. “A little time invested upfront can reap huge rewards in reducing questions on an ongoing basis.”

One challenge many clients will need explained to them is the length of their post-retirement years. Some may look at life expectancy data and think that represents a grim “finish line,” not realizing that it represents the age they have a 50% chance of living past. Clearly planning around the official life expectancy number is a high-risk bet.

“It’s like flipping a coin — heads you die, tails you run out of money. Not really a great situation to find yourself in.”

So while a female client may be “expected” to live to 84, a proper “planning horizon” is closer to 95 years of age. If she planned on retiring at the average planned age of 61, that 11-year gap represents about a 50% increase in the number of years she might live.

Cockshutt defines the planning horizon as the age at which you only have a 10% chance of living beyond. Grim though it may sound, most people would rather have a 90% chance of dying with money than a 50% chance.

And while Canadians are living longer, they plan to retire earlier and are entering the workforce later. They will need to build up larger retirement funds in a shorter period of time.

Taking the bumpy road

In today’s market, investors are still risk-averse, but may need to be convinced that risk can be managed, rather than just avoided. Often clients will look at their risk tolerance assessment and say, “this is the portfolio I am comfortable with.”

“The comfortable portfolio that they’ve chosen, is a comfortable path toward something that’s not their goal,” Cockshutt says. “Sometimes the bumpy road, the uncomfortable road that takes you to your objective is a more sound one. We need to have that discussion with our clients.”

Some investors take the stance, “At least with my GIC, I know where I stand.” But Cockshutt challenges this mindset. He cites an example of excessive risk avoidance using the recent past in the GIC market.

A $10,000 GIC purchased in January 1994, maturing in 1999, paid 4.25%. The investor is guaranteed a payout of $12,462 at maturity and feels he can sleep well with his investment.

Just six months later, the U.S. Federal Reserve has raised interest rates and a 5-year GIC is paying 7.88%. What is the value of the aforementioned investor’s GIC? The investor may claim it is worth at least his original $10,000; or he may tack on the interest earned to that point and consider his investment to be worth $10,213. He may hold to his long-term view and think it is worth $12,462, the full value at maturity.

But Cockshutt points out that to get a return of $12,462, the investor’s neighbour only needs to invest $8,852 at the current 7.88% for just four and a half years. The current value of the original investor’s GIC has actually dropped by $1,148, a loss of 11.48%.

So the “risk-free” GIC route is actually considerably bumpier in real terms than the investor may have believed.

In the short term, say one to five years, Cockshutt agrees that fixed income assets offer the best risk-return ratio. But he points to data that shows the best risk-return over a 30-year horizon is actually the familiar 65-35 split between equities and bonds.

“Sometimes what you want isn’t really what you need,” says Cockshutt. “It’s our job as the Sherpa to ensure our clients get what they need and ensure they stick with what they need when they should.”

While GIC investors are perfectly content to buy their locked-in fixed income product and ignore it for five years until maturity, mutual fund investors tend to obsess over every fluctuation in the NAV of their holdings.

It’s the job of the advisor to educate their client and help them maintain their investment discipline.

“Maybe we should take our mutual fun investing and wrap GIC behaviour around it and be a whole lot happier as a result,” says Cockshutt, encouraging the audience to share with their clients an article from AIM Trimark entitled “Learn to invest and forget.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(09/16/04)