Advisor analysis – Kenneth Stratton

Investing in the restaurant business is not for the faint of heart. Start-up restaurants have a high failure rate. This type of “investment” is a gamble that is magnified by Doug and Jeff’s lack of experience in the industry. Doug and Jeff’s starting point is to separate their illiquid – high risk – low probability gamble from investments in the capital markets.

Behavioural finance would describe them as showing classic regret-aversion bias. Similar to touching a hot stove, having experienced painful losses instinctively tells investors to avoid repeating a past behaviour – leading to errors of omission. In this case, Doug and Jeff risk being too conservative with their investments and, consequently, may not reach their retirement goals.

While Doug and Jeff claim a low willingness to take on risk, their net worth, stable income, and time horizon imply a higher ability to take on risk. The key for Doug and Jeff is to first emotionally let go of the restaurant loss and recognize that, by implementing a comprehensive plan, they will likely achieve their longer term goals. But there may be some guilt and blame to be addressed first. To establish that, I’d ask questions such as:

• How do you (Doug and Jeff) make financial decisions?
• Can you tell me about the key principles that guide your investment decisions?
• What have been your best and worst financial and investment decisions?
• How confident do you feel about your ability to fund your desired retirement lifestyle?

Will they achieve their goals based on their current savings and investable assets? Not knowing their full employment and savings history, I took the added conservative approach of assuming that: (i) neither qualifies for CPP or OAS, (ii) their savings are flat year over year, (iii) Doug’s cap on RRSP annual contributions limit his employer-matching contributions, and (iv) each of them lives to the golden age of 90.

Our projection indicates that Doug and Jeff require a 2.50% compounded return, a rate barely covered by GICs in today’s market. Intuitively, a 2.50% return is risky in itself with Canadian inflation currently running at 2.3% and the CRA happy to take 30–40% of any investment gain from a typical non-registered account. The risk by investing in “safe” GICs is loss of purchasing power. Manulife Mutual Funds has an excellent chart that shows the break-even return rates when factoring in inflation and taxes. If Doug and Jeff added equities to build a balanced investment portfolio, the expectation is that the amended portfolio could produce 5–6% annually in today’s market.

Projections based on the “safe” GIC rate and the conservative 5% balanced portfolio return will provide the couple with future income levels. The income difference between the two projections would be an indication of two future lifestyle outcomes. I’d then ask Doug and Jeff to answer the question: “How does that higher income change your lifestyle?”

If they agree that the higher income level would offer the kind of retirement they desire, I’d suggest they move in this direction by adding broad-based equity exposure through their existing monthly savings. This will give them the comfort that comes with knowing that their existing savings are in a secure investment and the new “riskier” investments will be added over time.

I’d be inclined to suggest exchange traded funds or mutual funds that offer broad-based equity exposure and eliminate the risk associated with individual sectors or equities. And less volatile or defensive stocks might be a good option for this couple. The reason: they tend to outperform the broad market over the long term because they benefit from smaller declines during market corrections while still increasing during advancing markets. Good examples in the ETF space include BMO Low Volatility Canadian Equity and Low Volatility U.S. Equity, and in the mutual fund space, the Sentry Canadian Income fund.

Doug and Jeff will need to establish check points to ensure their comprehensive plan is working by, for instance, comparing the actual value of their investments to their projected value within a reasonable tolerance that meets their plan each year. They’ll more likely stay invested in riskier assets if they can see that they’re achieving progress toward their long term goals.

In the end, fear has always posed a challenge for investors, but it should never be the driving force behind an investment decision. As financial advisors, we can be invaluable at helping investors to avoid behavioural traps and make or stick to investment decisions. An advisor can temper not only fear and uncertainty but also the other extreme of euphoria and exuberance.

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Information in this article is from sources believed to be reliable, however, we cannot represent that it is accurate or complete. It is provided as a general source of information and should not be considered personal investment advice or solicitation to buy or sell securities. The views are those of the author, Kenneth Stratton, and not necessarily those of Raymond James Ltd. or Rogers Communications Inc. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds and other securities are not insured nor guaranteed, their values change frequently and past performance may not be repeated. Raymond James Ltd. is a Member of the Canadian Investor Protection Fund.