(As published in Lifestyles 55 October 2012)
I have talked in past columns about ways an individual can minimize the downside in their financial plan, through tax planning and risk management. It is time now to look at ways of maximizing the upside. How can we be as successful as possible in our investment activity so that we might retire earlier and do more when we have become independently wealthy?
A friend of mine wrote a book “Don’t Sell Yourself Short”, to encourage others to seek personal financial success. The introductory chapter, after concepts such as investment opportunities, risk, liquidity and time horizons were explained, concluded with a section, “The Free Lunch”:
“You probably won’t be surprised to find that there’s no free lunch with investing. You have many alternative forms of investment available to you, most of which come down to a choice between lending to others and owning a piece of the business. Lending tends to be more predictable in terms of income and therefore less risky (i.e. volatile) than owning, but over the long term owning a piece of a business tends to generate better returns. It’s that simple. But investment advisors and many journalists and commentators make it a bit more complicated. The lack of a free lunch means that if someone promises you a very high return on an investment, he is either exaggerating, or is asking you to undertake considerable risk.”
On the other hand, I recently reviewed an article on “the growing popularity of a global allocation and risk management strategy known as risk parity”. Its first tenet was that diversification is the one Free Lunch of finance. To the extent that two assets in a portfolio are not closely related, the cumulative risk (volatility) will be less than the sum of the risk of each individually. That is a “free lunch” factor: you have a chance here – indeed two chances – at that higher return on your investment, but your overall risk is somewhat diminished.
So the answer to “where should I invest my money for the best return” is to diversify your investments. Use a mix of fixed income and equities, of registered and non-registered funds, of insurance and growth.
One example of a well diversified portfolio, with limited downside risk but reasonable upside potential is the Canada Pension Plan. Its operating principle is: “The cornerstone of a successful investment strategy is effective risk management. We are required to adhere to investment policies, standards and procedures that a prudent person would exercise in dealing with the property of others.”
Most of us would consider that a sound policy for our own money. If you wish to generate the best upside on your money, you should not be limiting yourself to GICs (which can give negative returns after tax and inflation). The CPP portfolio is 50.9 per cent in equities, and of the 2,500 companies it holds, only 400 are Canadian. United States and global equities are needed for maximum diversification.
If you have a seven-figure portfolio, several hours a day to study markets, and subscribe to better (not free) investment newsletters (and read all of my friend’s book), you could do diversification yourself. But most of us will rely on “professional” advice from people who do make it a living by studying these subjects. So here is an idea: you could diversify your advice. Make use of your accountant, lawyer, banker, insurance advisors and investment sales. You could even diversify your portfolio by placing investments through two or more advisors.