There is a scene in the American film classic Butch Cassidy and the Sundance Kid where Wild West outlaws Paul Newman and Robert Redford find themselves perched on a ledge 100 feet above a raging river. They are penned in by a crack U.S. posse.
“We jump.,” proclaims Newman. “They’ll never follow us down there”.
“No” responds Redford.
“Why not?” demands Newman.
“I can’t swim,” confesses Redford sheepishly.
Newman laughs saying, “hell, the fall will probably kill you!”
This is an epic example of risk management on the part of Redford. Surprisingly, risk management is a paramount part of the process of building financial security. Let’s say that you have decided to set aside five to 10 per cent of your income in order to achieve a comfortable retirement. You want to do what you can to avoid the risk that you will outlive your savings. How should you proceed?
There are two common investment tools. These are guaranteed investment certificates (GICs) and mutual funds. Close inspection of either of these financial investments leads you to that four-letter word, risk.
A GIC is an interest-bearing investment that usually comes with a principal guarantee. This means that the funds that you invest are guaranteed to remain in place even if there are downturns in the economy. At first, this may sound pretty risk-free, but consider the impact played by gritty inflation. Our central banks have suppressed interest rates to ultra-low levels. If your GIC is paying 1.5 per cent but inflation is two per cent, it may be impossible to make your retirement goal. This is called inflation risk.
Mutual funds provide the opportunity for growth above inflation, but again there is that four-letter word. How do they work? A mutual fund is a vehicle for pooling investors’ money. A fund manager is mandated to follow a specific set of objectives while investing those pooled dollars in a large variety of businesses.
As an average mutual fund investor, you participate in about five funds. As a result, collectively, your money is spread out over a few hundred companies. You have a diversified investment. As the share prices of those companies rise and fall, you share in the results. What is your risk? Historically, mutual funds fall in value one-third of the time. Over a seven to 10 year period, however, the two-thirds of profitable years are usually enough to bring your overall average returns, after management fees, to between two to four per cent above inflation.
How can you effectively manage these investment risks? In most cases, a combination of these two products is a great start.
The answer is to have a financial plan customized to your situation. The investment mix required to meet retirement goals will be different if you are a double income family in your mid-30s than it will be if you are a 60-year-old single person. A consultation with a financial planner will help with this.
Every dollar of savings should have a different job description. If you are going to be in need of your money in the foreseeable future, you will not want it vulnerable to the kind of 35 per cent drop in value that happened to mutual funds in the 2008 recession. Park those dollars in GICs.
In this case, you are giving up return for liquidity. Money that has the tough job of long-term growth, where temporary dips in value won’t cause you financial hardship, should do well when invested in quality mutual funds.
Once the just-for-you investment plan is underway, plan for annual reviews to track your progress. If your current situation changes you can always make appropriate adjustments.
Are you ready to take the leap?