Two of the first questions that an investment advisor must (by law) ask each new client, is ” What are your investment goals” and “What is your risk tolerance”?
These seem like simple questions. In reality they are both very complex questions. The vast majority of investors have never really thought through their goals or risk tolerances and they are in no position to provide well thought out answers to these questions.

For investors who are still in the working and saving phase of their life, the first reaction that often comes to mind as a goal is “to accumulate as much money as humanly possible by retirement age”. However while very attractive, this goal is usually too simplistic and fails to take into account exactly how and when you might spend this nest egg.

Investors need to have well thought out goals because your investment goals (and not your sleeping patterns) should directly determine how much risk you can afford to take and therefore how your money should be allocated between stocks, bonds, cash and other asset classes.

Risk tolerance is often approached as if it is simply a matter of individual preference. In reality it should be approached as a question of tolerance, not preferance. Higher risk over long period of times is strongly correlated with higher returns but it is not a guarantee. Risk tolerance is mostly determined by how soon the invested money is needed for spending and what the consequences are if the investment declines in value due to risk.

Money that is needed for next year’s groceries should not be put at risk even if the investor psychologically loves to gamble.
I recommend that investors first think about when they will need the money and what are the consequences of not having the money when needed before deciding on their investment goals and risk tolerance. The typical investment process can be broken down into a number of levels that may be attained over a lifetime.

Every working investor should consider setting aside a certain amount as an emergency fund. This money should be outside of an RRSP and should be in low risk cash or short term investments and definitely should not be in an investment that you cannot or would not want to liquidate as soon as required.

My view is that this fund is not needed to pay for things like an unexpected medical expense or a new roof on the house. Those expenses can be handled through a line of credit. The reason an emergency fund is needed is that almost all workers are at least somewhat vulnerable to sudden job loss. If you lose your job you won’t want to use a line of credit for living expenses as this would drive your stress levels through the roof. If you expect a severance on job loss, you still need the emergency fund since it may take several months or more to negotiate and receive your severance settlement. An emergency cash fund will allow you to comfortably take your time and negotiate a reasonable severance settlement.

Two income families could forego the cash emergency fund if they can get by on one salary. Also if you think your job security is iron-clad then perhaps you don’t need an emergency fund.

Every investor should consider that there is at least a small chance of becoming totally and permanently disabled. Many Canadians have little or no disability insurance, particularly against disability caused by illness. This is perhaps best handled by purchasing disability insurance. But this insurance (except through certain employee group plans) is quite expensive.
Unlikely but possible contingencies can also include getting involved with an expensive legal battle or an expensive divorce situation.

Even though you may have a very long term time horizon for your investments, there is always some chance that something major and unexpected will happen and you will need to dip into your long term savings. This is one of the reasons that most investors should not lock up all of their investments in stocks since there is always a chance that you will need to access cash quickly, and you would not want to be forced to sell stocks at an inopportune time.

Almost all investors should have as a major goal, the maintenance of a reasonable minimum life style in retirement.

A 100% stocks strategy has the best chance of making you really rich but also has some small chance of leaving you with a completely inadequate lifestyle, so you need to think very seriously before you choose a 100% stock allocation. If you go 100% stocks, the percentages are on your side and you will probably win in the long run. But you only have one life to live and even though the risk is small you don’t necessarily want to risk living in poverty when you could have locked in at least a minimally comfortable lifestyle with a more balanced – and lower risk – allocation.

We all buy fire insurance on our houses even though it is extremely unlikely that our house will ever burn. It is this same rationale that would cause us to give up some of the potential up-side from stocks and invest some money in safer assets in order eliminate the remote chance of poverty in old age that could be caused if stocks tank for decades.

Anyone not eligible for CPP should take this sustenance requirement most seriously.

Similarly, those without good pension plans need to be careful to insure they can fund an adequate lifestyle a even if the stock market tanks for decades.

Thos who are eligible for full CPP, old age pension and a good employer pension may be able to ignore this sustenance level completely. With an adequate level of comfort already assured, these investors can afford to go for the gusto and could consider a much higher stock allocation in their investments.

Once investors have assured themselves of an acceptable sustenance level in retirement, the next step is to save for and ultimately lock in a reasonable level of comfort and freedom.

This would include the ability to travel somewhat and perhaps to spend a month or two in southern climes each year. This would equate to an upper middle class lifestyle maintained throughout retirement.

Investors reaching this stage probably have the equivalent of at least $2 to 3 million in wealth (including the value of CPP and all pension plans, which are often well over $1 million) as they enter retirement.

This will fund a fairly luxurious lifestyle.

It also allows for a large estate to be passed on to offspring or a favorite charity.

For most investors this would require an aggressive approach with a very significant allocation to stocks combined with heavy savings for many years. It may also be funded through ownership of a very successful business.

I believe that most younger investors would like to get to Level 5 or at least to Level 4.

But just because we want to get to level 5 does not mean that we should be overly aggressive with our entire portfolios.

My view is that we should mentally (or physically) segregate our investments and lock in each Level one at a time before moving on to the next level.

Many of us are muddling along sort of working on all the levels at once, and not really approaching the problem rationally.

For example, some investors (think ENRON employees) did very well on tech stocks and were well on their way to securing a Level 5 scenario. But they failed to set aside a sufficient portion of their funds to lock in Level 4 or even Level 3. In the most extreme cases they now face a a struggle for much beyond bare sustenance in retirement when they could have easily locked in an upper middle class lifestyle – for the rest of their lives. And they did this by chasing extra dollars in the Level 5 scenario that would not really have changed their lifestyle much at all, at that point.

As investors accumulate enough to fund each level they should then focus on capital preservation to lock in each level.

A typical scenario would be the following:

In the 20’s to mid 30’s pay off any student loans and accumulate a 3 month emergency fund. Keep this fund invested in cash and money markets permanently. Forget about RRSP contributions until this is done. The RRSP “room” will probably be worth more to you later as your salary increases.

Next begin maximizing RRSP contributions. With any extra cash, pay down the mortgage. At this stage I suggest being fairly aggressive with a heavy or even 100% allocation to equities to achieve the highest probable returns. Some portion might be kept in cash in respect of Level 2 the need for sudden
contingency money on a longer term basis.

Completing Level 3 to insure sustenance in retirement could take several decades and depends heavily on the existence of a pension plan. As Level 3 becomes more assured begin to focus on locking in this layer of your retirement money by moving increasingly into shorter term bonds and away from equities. About 25% might be permanently left in equities in order to protect against inflation.

Those with good pension plans and very secure jobs may consider moving directly to Level 4. In this case the mortgage should probably be paid off first in order to be more sure that Level 3 is in fact locked in.

By the time the mortgage is paid you may have locked in Level 3 and you are moving into funding Level 4.

Often Level 4 may involve investing outside of the RRSP. At this point much of the RRSP has moved into fixed income investments to lock in Level 3 and the non-registered plan should focus on a large allocation to equities and can be more aggressive.

After another decade or so, Level 4 may be assured. As Level 4 becomes assured it is logical to lock in this level by focusing on capital preservation and moving away from riskier investments and into more fixed income, leaving perhaps 25% in equities to protect against inflation.

Eventually, some investors can completely lock in level 4 and finally begin working aggressively on Level 5, safe in the knowledge that at a minimum they have already locked in an upper middle class lifestyle for life. Even the oldest investoirs may keep a large portion of their “Level 5” investment in equities since the time span for spending this money may be after their ultimate deaths and since they don’t depend on this money for their lifestyle.

It is no wonder that investors don’t give logical answers when asked about their investment goals and risk tolerances or preferences. First they have not really thought about it. Secondly, it is not really a logical question, as posed.

Investments should be thought about in layers. No investor should claim to ignore capital preservation in favor of maximum (probable but risky) capital growth. Instead each investor should have different goals and risk tolerances appropriate for each level.

The above scenario is not a totally clear-cut path. For example, each investor has to discuss with their advisor how much money is needed to reach each Level threshold. And this will likely change as the investor’s salary and time horizon changes.

But thinking about your investment goals in terms of these successive levels should add to your clarity of thinking. Rather than being overly conservative or two aggressive, you can think about how much money you NEED to be conservative with in order to lock in sustenance, comfort, or relative luxury, depending on your own situation, and then how much is left with which you can afford to be much more aggressive.