Reaching Your Financial Goals

January 17, 2017

As we begin a New Year, I thought it might be interesting to write about investment objectives, portfolio construction and maintenance, and then finish with a brief review of performance and how dividends are accounted for on client statements. I will start by recapping some generic industry terminology that should be used when constructing a diversified portfolio. Hopefully this article serves as a reminder as to the importance of setting a well thought out financial plan and then sticking to it.

Understanding Commonly Used Definitions of Risk

Correlation is a measure of how different investments perform in relation to each other and will range in value from -1 to 1.

  • A correlation of 1 means that if one security goes up, the other will also go up and vice versa
  • A correlation of -1 means that if one security goes up, the other will go down and vice versa
  • If two securities have a correlation of zero then there is no relationship between how the two react

If your entire portfolio is positively correlated, then your holdings will go up and down together creating volatility. By adding securities that are not correlated or that have negative correlation, you should reduce the portfolio volatility and thus risk. The good news that by buying something that is not correlated or that has negative correlation, you will probably own something that is doing well when nothing else is. Of course, the bad news is that you may own something that is doing poorly when everything else is doing well. Adding a positively correlated security may slightly add to your diversification but buying an uncorrelated security will greatly add to your diversification and likely reduce your risk significantly. Remember that two stocks can get to the same return over the long run even if they have a negative correlation so do not abandon a negatively correlated investment when it is underperforming your other investments. Remember that is why you bought it: to react differently from your other investments. This is an important factor to consider when constructing a portfolio.
Beta is a measure of the magnitude or volatility of an investment when compared to the market and its value can be positive or negative.

  • If you own a stock that has a Beta of 1 and the market goes up 10%, that stock should go up 10%
  • If you own a stock that has a Beta of 2 and the market goes down 10% that stock should go down 20%
  • If you own a stock that has a Beta of 0.5 and the market goes up 10%, that stock should go up 5%

As you can tell from the above examples, if you equate risk with volatility, then owning a lower Beta stock will help reduce the risk of a portfolio. Of course, you give up some upside to get better downside protection. As an example, a typical gold stock has a 3 year Beta of 1.5 and a typical, more conservative utility company has a 3 year Beta of 0.6. Keep this characteristic in mind when constructing a portfolio when trying to keep your risk down.

Understanding Portfolio Construction & Maintenance

The most important part of meeting your long-term financial goals is to put together a solid, well thought out financial plan and then stick to it. This plan is not something that should be rushed or taken lightly as it should be the roadmap to your reaching your financial goals. It needs to be realistic, account for your risk tolerances, set out clear objectives, and be longer term in nature. Almost every investor will say that they want to make 10+% return with limited downside risk. This falls into the not realistic category when you consider the long term return of the Canadian equity market is approximately 8% and investment grade bonds currently yield about 2.5% (or less). It is best to have a plan, before constructing a portfolio so as to avoid excessive risk.

If you are looking for upside potential and can handle a loss of 20% (or more), then a portfolio with significant equity exposure may be best. Your portfolio will have the potential for higher returns but will likely come with more volatility, a high Beta, and you will likely end up with holdings that are highly correlated to equity markets. Nothing wrong with this if you understand the long-term nature of your investments and can look through short-term fluctuations. In this case, you should set an aggressive expected return target understanding that there will be significant volatility.

If you struggle with losing your hard-earned money but still need growth, a significant bond position may be appropriate mixed in with low Beta investing strategies and maybe a lower risk alternative strategy or two. Your portfolio should have less volatility than an aggressive strategy but there will still be some. This investor should have a portfolio with a lower Beta and should own investments from asset classes that are less correlated to the equity markets. The expected return should be lower than an aggressive strategy as the financial plan should include a way to keep volatility down.

If you have managed to save a lot of money and want to maintain your portfolio while drawing an income from it, then a combination of bonds, equities and uncorrelated alternative strategies may be the right fit. Target a lower expected return with significantly reduced volatility.

There is always a trade-off. Targeting higher returns will likely mean more equity exposure which means more correlation between your holdings, a higher Beta, and more volatility. When constructing a solid, long-term financial plan, you need to find the right mix of return expectations and acceptable volatility realizing that having less risk will likely lead to lower returns.

Once you know your financial objectives and have put together a financial plan, then your portfolio needs to be maintained. While this sounds easy, staying unemotional and not chasing returns is the most difficult part of investing. Most investors look to buy what is “hot” and sell what is not which is akin to buying high and selling low; never a good investment strategy. If you have a carefully constructed plan to be 70% in equities and 30% in bonds and in year one, the equity market goes up 20% and the bond market goes down 5%, many investors want to sell their underperforming bonds to buy more equities. Unfortunately, if you do this then creating your financial plan was a waste of time. After a year like above, your equity position would be approximately 75% and your bond weighting would be approximately 25%. To stick to your plan, you should sell 5% of your outperforming equities and buy 5% more of your underperforming bonds. A disciplined investor will remember why they bought each position and understand its role in the overall portfolio. If you purchased something with a negative correlation to equities, it does not make any sense to sell it after a strong run in the equity market but emotion takes over and that is often what happens. By buying something with a negative correlation to equities, the fact that it is down in a positive equity market should not be a surprise by the very definition of the investment. That investment was made to protect your portfolio in the inevitable down equity markets. Selling it to chase something that is up will increase the correlation of your portfolio and thus increase the portfolio volatility and the risk. Below are some examples that will hopefully at least give you pause before chasing returns:
The 20 year return of the S&P 500 for the period ending December 31, 2015 was 9.9% per year. A study by Dalbar Inc. showed that the average equity investor in the S&P 500 returned only 5.2% per year over that same time period. The study shows that after the stock market went up, investors put more money into it and after it went down, investors pulled their money out resulting in a buy high and sell low situation. The emotional aspect of investing had a significant impact on these investors as they did not stick to their financial plans.

While this second study is a little dated, it clearly shows the pitfalls of chasing returns rather than showing patience. Fidelity Investments conducted a study on their Magellan Fund during Peter Lynch’s tenure from 1977-1990. In this 13 year time period, the Fund posted an average return of approximately 29% per year. The study showed that the average investor in this fund actually lost money. Clearly the fund was volatile and investors bought after a good period and sold quickly after weak period. Another example of buying high and selling low.

As stated at the beginning of this section, the most important part of investing is creating a well thought out long-term financial plan. After that is done, understand the “job” of each component of your asset allocation so you are not disappointed or surprised when everything does not go up at the same time. Finally, stick to your plan and do not get emotional by chasing returns. This is not easy to do which is one of the many reasons why financial advisors are so important. Let them stay unemotional and trust them to execute the plan that you agreed to as it is much easier to see the big picture if you are less emotionally attached.

Examining Performance

Over the past few years, the investing world has changed to the point where more emphasis is placed on how much you are paying in fees rather than how an investment is actually performing. This smoke and mirrors routine is often being undertaken by investments that have not performed well in an attempt to try to shift the focus away from what is truly important. Unfortunately, it is working. As an investor, would you rather make 10% (after paying 1.5%) or make 6% (after paying 0.5%)? In today’s world, many investors would indicate the latter. This brings us to the very important point that funds report their performance NET of fees. In other words, when comparing investment opportunities, you can just look at the numbers and determine which one would have put more money in your pocket. Remember that your investment objective probably referred to making a certain percentage return with a given level of risk. I doubt your investment objective was to pay low fees without reference to performance. I am not suggesting that fees are not important but sometimes you get what you pay for. If you are doing a home renovation, would you choose the lowest cost contractor if it is their first job or would you pay a little more for an experienced professional with a successful track record?

An investor needs review performance in conjunction with their investment objectives. If you reached your goal to attain a return 8% with lower volatility, does it make sense to compare it to your neighbour’s 15% returning portfolio whose goal was to maximize their return with no consideration of volatility? Too many investors chase funds, stocks and even change advisors to get those higher returns only to realize later that the increased risk is something that they cannot handle.

Understanding Dividends

These days, it seems like every investor wants a dividend attached to everything they buy. Before we go any further, it is important to understand that dividends are not bonuses; they impact a stock or fund. If you own a $10 stock that pays a $1 dividend, the stock will drop to $9 the day that it trades ex-dividend. While it may not trade at that level, the stock going ex-dividend will influence the price. The same goes for funds. If a fund that closes the day at $25.00 pays a $1.50 dividend, it will be worth the same $25 only it will now be in the form of a fund valued at $23.50 and a dividend of $1.50. If you re-invest that dividend, it is as if the fund gave you $1.50 and you used that $1.50 to buy additional shares. You will have the same amount of money only it will be in the form of owning more shares of the fund at a lower price. Also, by reinvesting, the book value of your investment will increase by the amount of the dividend even though you are not out of pocket any additional money. This impacts how your monthly statements look and is probably best shown through an example.

Suppose you buy 10,000 shares of a fund at an initial price $10 for a total investment of $100,000. Let’s assume that the fund returns 10% in the first year to close with a price of $11.00. Your statement will look like:

Fund #Shares Price Per Share Book Value Market Value
XYZ Fund 10,000 $11 $100,000 $110,000

When you compare your market value to your book value, you will notice that it is $10,000 or 10% higher. 

Now, let’s look at the impact on your statement if the fund goes down 5% in the second year under three different scenarios: (1) no dividend is paid at the end of year one, (2) a cash dividend of 6% is paid at the end of year one, and (3) a re-invested dividend of 6% is paid at the end of year. Note that in all three circumstances, you have not added any additional money so nothing had changed in terms of your initial investment.

Fund # Shares Price Per Share Book Value Market Value
Scenario #1 10,000 $11 $100,000 $110,000
Scenario #2 10,000 $9.823 $100,000 $98,230
Scenario #3 $10,683.3 $9.823 $106,600 $104,500

Under scenario #1, losing 5% on a market value of $110,000 will mean that you now have $104,500. On your statement, it will show that after two years, the market value of your $100,000 investment is now $104,500 for a profit of $4,500. 

Under scenario #2, paying out a cash dividend of 6% on $110,000 will mean that you received $6,600 in cash ($0.66 per share). That $0.66 payment will reduce the end of year fund price per share to $10.34. If that $10.34 per share drops by 5% in year two, it will end the year at $9.823. Your statement will still show a book value of $100,000 and it will now show a market value of $98,230. It will look like a loss of $1,770 on your statement. If you did not realize that you received a dividend, you may be unhappy with this investment. Of course, if you remember about the dividend, you will realize that you have profited $4,830.
Under scenario #3, paying out a re-invested dividend of 6% means that at the end of year one, you will have 638.3 more shares of the fund but at the after dividend price of $10.34 (see scenario #2). If that $10.34 loses 5% of its value in year two, the price will drop to $9.823. After multiplying your new number of shares by the second year end price, you will notice that you have the same $104,500 market value that you had in scenario #1. Unfortunately, by paying a $6,600 dividend in additional shares, the book value on your statement increases by that same amount even though you have not technically added any additional money. By just looking at your statement, it would appear that you have turned $106,600 into $104,500 which is a loss of $2,100. In reality, you have made $4,500.

The bottom line is that net profit as described by money over and above your initial investment remains almost the same whether the fund pays a dividend or not, despite how it may look on your statement.

Understanding what your financial goals are and how you can go about attaining them without taking on more risk than you can handle is a great New Year’s resolution. While best done through a financial advisor, be prepared to ask questions so you can understand how your future retirement is being invested. After the plan is in place, sit back and let your advisor make the unemotional decisions needed to reach your goals.

For More Information:

Keith LesliePortfolio Manager

He has over 20 years of investment management experience. Prior to joining NCM in 2001, Keith worked as a Quantitative Analyst at a western Canadian investment firm. Keith brings a different perspective to the firm’s investment process, using statistical techniques, valuations…

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