Clients face different hurdles depending on which stage they are in their investment-planning process
The Canadian Securities Administrators (CSA) has mandated a risk classification methodology that uses return volatility as a measure of risk. Some have questioned the usefulness of the system, pointing out that basing risk purely on return volatility doesn’t account for all the challenges that consumers face.
That’s the same line of reasoning followed by a US-based investment management firm. In a new whitepaper titled Redefining Risk: The Revolution Coming to Financial Service, the firm argued that risks actually vary over time, particularly when it comes to retirement planning.
“Historically, advisors and investors have looked at retirement planning and portfolio construction in terms of style boxes and Modern Portfolio Theory,” said Robbie Cannon, CEO at Horizon Investments. “These remain important tools, but individuals tend to define risk differently – primarily as their ability to achieve a specific life goal.”
The paper presented a retirement investing model with three stages, each with their own risks:
- Accumulation – when the client is actively investing to grow enough assets to fund their retirement goals;
- Protection – when assets must ensure the funds for their retirement aren’t jeopardized; and
- Distribution – when the client starts actively using their accumulated assets.
In Horizon’s view, volatility is the dominant risk during the accumulation phase. In this early stage, investors are decades away from needing to access their wealth; this investment horizon is the closest they can get to the long-term time frames used by institutional investors, which view risk as volatility.
“[In addition,] we know that clients tend to want to do the “wrong” thing at the wrong time, based on the movements of the markets,” the report said. “In times of intense volatility or declining markets, they often want to sell their portfolio to reduce risk—a decision that often leads them to end up paying a higher price later on when they want to buy back the portfolio.”
During the protection stage, which is typically starts a few years before the distribution stage, drawdown becomes the major risk. Aside from the direct threat they pose to achieving retirement goals, absolute dollar reductions in an investor’s assets become harder to recover from, so they have to keep more money in their pocket.
“There are multiple ways to address this risk, including investing in low volatility stocks, using options-based strategies, or implementing an active de-risking approach,” Horizons said. “[However,] a balance still must be struck between building wealth and protecting wealth during this stage.”
Finally, according to the paper, clients at the distribution stage must focus on longevity risk — the possibility of exhausting one’s assets before their retirement goal is completely funded. This challenge has implications on one’s investment strategy — withdrawals should be made with current income and future income in mind. It also argued that the traditional approach of minimizing volatility by rebalancing toward fixed income as one goes into retirement may not be the best approach; to combat longevity risk, as well as accumulate legacy wealth for heirs, an equity tilt may be more appropriate.