Core - Surplus
Let’s double-click on my last post. In it, I suggested that despite being the consensus view, I do not think it is necessary to assume that some portfolios are low risk while others are medium or high. To me, a more practical approach in private wealth management may be to simply say that something either is, or is not, risky.
Our team encourages clients to divide their wealth into two buckets – core, or risk-off, and surplus, or risk-on.
From our perspective your core capital is an amount of money that you should not take risks with. It is the money needed for shorter-term objectives. Perhaps it is the amount you need to cover your regular expenses for the next five to ten years, or it may be earmarked for larger outflows over a similar period – new car, tuition, dream vacation, new home or rec-property, etc. For clients who do not have stable employment, pension, or other business income to cover these outflows, we suggest setting this money aside. It can be invested in GIC’s, High Interest Savings Accounts, or other short-term, risk-free, solutions.
The more conventional approach is to invest all your wealth in one portfolio, likely a lower-risk, or more conservative portfolio. For some, this works. And that is okay! However, we think this approach misses the mark. If we agree that we cannot predict future returns, for better or worse, then it seems misleading to suggest that investing in a lower risk portfolio provides the same assurances as keeping the funds you need in the short run in risk-free investments. Afterall, 2022 taught us a very important lesson: low risk portfolios can fall by uncomfortable amounts, as well.
This is why we first ask “How much of your life savings do you want to take risk with” instead of, “How much risk do you want to take with your life savings”. The distinction offers several important benefits.
Obsessing over one’s time horizon and only taking risks with funds that can be invested for the next ten-, twenty-, or thirty-years can help mitigate the risk of an un successful investment outcome. To be clear, it does not guarantee success, but in our view, it is the best tool we have. By working closely with clients to ensure their risk-off bucket, or core capital, is sufficiently funded, we can be confident that any funds invested in the risk-on bucket – one’s surplus capital – are truly committed to a long-term investment strategy.
We believe our core-surplus framework also sets investors up for a more comfortable investment journey. It is one thing to set up a long-term investment strategy and another to stick with it. Investing can be emotionally trying; you have to keep your head when others are losing theirs. You will experience several episodes of significant volatility over a sufficiently long investment horizon. It is when your investment portfolio is down the most that your resolve needs to be the strongest. If you have already set aside the money you need, it will be much easier to keep your head and wait through any storm with your risk-on assets.
Finally, financial plans are path dependent. That is a fancy way of saying that the sequence of returns really matters. If you are forced to sell investments when your portfolio has dropped in value, locking in a loss, you can end up completely off course. Proactively setting funds aside to cover five to ten years of outflows helps avoid this fate.
In future entries, I will discuss how one might invest his or her surplus capital; and more specifically, how we invest it for our clients. For now, here are the key takeaways of our views on risk:
- Risk is related to the outcome you did not expect and/or cannot sustain.
- There is no way of knowing that one portfolio of risky assets will be less volatile than any other in the future. Deal with the unknown, do not gloss over it.
- Risk is binary – you are either taking risk, or not taking risk.
- One’s time horizon is the most important consideration when making an investment allocation. To be clear, you should not take risk with funds that are needed in the short term.
The information contained herein has been provided by Fry Ormerod Wealth Advisory Group and is for information purposes[SI1] only. The information has been drawn from sources believed to be reliable. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. Fry Ormerod Wealth Advisory Group is part of TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc. which is a subsidiary of The Toronto-Dominion Bank.
