Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com
What can Canadians learn from our country's most knowledgeable investors?
Recently, I had in-depth conversations with the managers running the money at three of the Canada's largest and most sophisticated pension plans.
Over the years, my investor research and consulting work with financial institutions has led to lots of conversations with individual investors about how they make investment decisions.
Here are four things Canadians can take away from the philosophy and process used by institutional investors.
Focus on returns after inflation
Ask many investors their goals for the return on their portfolio and they'll give you a number that might be 6 per cent, 8 per cent or even 10 per cent. The industry calls these nominal returns - the money you make before taxes and inflation.
Suppose you gave the average investor two choices: One features a 10-per-cent return when inflation is 5 per cent, the other an 8-per-cent return when inflation is 2 per cent.
Many would pick the 10 per cent, even though it only yields 5 per cent after inflation. Ask a sophisticated investor the same question and they'll go for the 8-per-cent nominal return and the 6-per-cent after inflation every time.
Define your target return
To meet their long-term obligations, pension plans start by hiring actuaries to regularly update the after-inflation return needed to meet their long term obligations - this might be anywhere from 3 per cent to 6 per cent.
That calculation shapes every aspect of their investment philosophy and process - the goal is to take on just enough risk to hit the real return needed to hit their goal.
This calculation isn't a static process - it is updated regularly to reflect tough years for markets such as 2008; as a result, sometimes companies and employees have to increase contributions to maintain the pension plan's long-term solvency.
Investors need to go through the same process. When opening accounts, many are asked how much risk they want to take - to which the understandable answer these days is often "as little as possible."
That's exactly the wrong way to think about risk. The right question is not how much risk you want to take but rather how much you need to assume in order to achieve your long-term goals.
Focus on equities
Ten years ago, many large pension plans invested heavily in government bonds. Today, most institutions sharply curtail the percentage of their portfolio in bonds, typically to well under 50 per cent.
The reason is very simple. If you need a return of 4 per cent or 5 per cent after inflation and government bonds currently pay about 3 per cent, it's mathematically impossible to hit your long term objective with bonds alone.
It all comes down to the return you need. If you only require a 2-per-cent-after-inflation return, you may be fine with bonds and GICs for the bulk of your portfolio. Bear in mind that if held outside of your RRSP, those returns are subject to tax - so if you're paying tax at the top rate, a 4-per-cent return before tax becomes about 2.5 per cent after tax, with inflation still to account for.
Most investors are in the same situation as large pension plans - while government bonds can stabilize short-term returns, at today's interest rates it's unlikely that bonds alone will get typical investors where they want to go.
By contrast, over the long term, U.S. equities have returned 9 per cent, leaving a 6-per-cent real return after inflation. Even if you scale back your expectations on equity returns to 6 per cent or 7 per cent, given that most economists forecast continuing low inflation for the period ahead, stocks will still yield returns after inflation and taxes that you're going to be hard pressed to match elsewhere.
Maintain a long-term view
The price of those superior returns on stocks is the short-term volatility that we have to live with along the way.
The last year has tested investors' tolerance for volatility - today some have a different view of the level of short-term risk they can live with than was the case a year ago.
The first rule of investing is "know yourself." It may be that a big stock weighting entails more short-term risk than you can live with. There's nothing wrong with that, provided you revisit the assumptions that underpin your retirement plans and are prepared to build in lower expected returns, rethinking when you retire and your retirement lifestyle as a result.
In my conversations with individual investors over the past year, I've often heard people say that they're looking for insight and perspective on what they should do going forward. When it comes to guidance on investing, there are few better places to start than with Canada's largest and most sophisticated investors.
Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com