Over the last few weeks, our team has been introduced to new clients who currently hold larger cash balances. Through no fault of their own, many had felt uncomfortable with the immense Covid-19 market volatility and had liquidated their investments. As of late, some have even felt panic and regret when they recognized they were not participating in the extraordinary positive market recovery. Investing has never felt more emotional, and the path towards investing is not clear.

As portfolio managers, we discourage binary portfolio positioning of being “all-in-cash” or “all-in-stocks”. That kind of positioning is more akin to gambling. The former is a “bet” that markets must fall and the latter “bets” that markets must rise. We concede that we do not know what the future brings, however, investing for risk-adjusted returns focuses on rebalancing the mix between risk assets and risk-free assets. Hence, we believe portfolios should always have a proportion that is participating in the stock market.

Before reinvesting cash into the markets, investors should reflect on how they felt during the market collapse in March. A panicked response to a declining portfolio is a hint that the portfolio may have been invested more aggressively than the client’s true risk appetite. How much risk can you take? This is traditionally asked through questionnaires that we feel have little value. After all, when markets are rising, we may be influenced to take on more risk. Anecdotally, we all believe ourselves to be “long term investors” until we are faced with real losses!

Risk has both objective and subjective sides. We believe risk should be differentiated between A) one’s ability to take risk and B) one’s willingness to take risk. The former is an objective measure of your financial means to withstand market uncertainty and the latter is a subjective emotional tolerance to uncertainty. Through decades of financial planning, our team has met many clients who have the ability to take risk but are unwilling to take it and those that are willing but don’t have the ability. An advisor’s role is to assist clients in finding a balance point in the teeter-totter between ability and willingness.

A properly constructed financial plan can be valuable in determining one’s ability to take risk. A plan that only shows one base case where asset prices are rising at favorable rates has little value except for making one feel overly confident. In our view, the best financial plans will present at least one scenario that elicits some stress! This perspective comes from our background as analysts and portfolio managers. After all, even the well-capitalized Canadian Banks undergo frequent stress tests to see if they can survive various blows to the economy. Similarly, individual investors should also stress test their own family balance sheets to determine their true ability to take risk.

A proper financial plan should be able to answer the following questions:

• What if expenses rose by 50% or 100% due to intended/unintended life changes?
• What if my portfolio experienced a collapse today of 20%, 35%, 50% ?
• What if my investment returns are much less than the base case?
• What if my finances experienced everything above simultaneously?

This is a vital step in determining one’s ability to take risk. How would an investor have reacted differently during the most recent bear market if they were equipped with the knowledge that their financial goals and standard of living would not be impacted by a 35% drop in the markets? Would the investor change their mix between stocks and bonds if they knew they only had to earn an average of 3% per year to fulfill all their financial life goals?

Before one reinvests their cash back into the stock market, they should have an understanding of how much risk they are able to take and what returns they actually need. Without having these targets and milestones it becomes incredibly difficult to know how to position their portfolio for the future. After all, runners don’t often start a race without knowing where the finish line is. We recommend speaking with a wealth advisor and portfolio manager to show you the course before reviewing the investment implementation plan (to be covered in Part 2 of this blog, coming soon!).