Stop thinking about your risk tolerance so much...and consider your risk capacity, writes Rob Carrick, reporter and columnist for The Globe and Mail.

August was a month where Canadian investors were big on reducing the risk level in their portfolios.

Mutual-fund industry data show they did this by dumping investments in the stock market and buying bond funds and balanced funds, which muffle stock-market risk with big holdings of bonds. These are defensible moves from a risk-tolerance point of view. But in terms of risk capacity, they could be problematic.

Risk tolerance addresses how much financial market turbulence you can stand, emotionally. Risk capacity is about the amount of risk you need to meet your financial goals. Obviously, the two aren't always compatible. Living up to your risk capacity can overtax your risk tolerance, and investing according to your risk tolerance can leave you well below your risk capacity.

To simplify: Stop thinking about your risk tolerance so much, and consider your risk capacity.

"In the long term, there is no free lunch," said Bill Horton, chief investment officer at MD Physician Services. "Unless you take some risk, you're not going to get a commensurate return."

There's a lot of suspect reasoning that goes into today's conservative investing trend. One factor, Horton says, is recency bias. That's where people base their expectations for what's to come on recent experience. In financial market terms, that means thinking bonds will keep outperforming stocks.

If you've been getting more conservative in your investing, here are two key pieces of information:

  • One, bonds could be a money-losing investment in the next several years.
  • Two, relying on safe investments may not get you where you need to be in terms of reaching your financial goals.

Horton's firm specializes in financial advice for people in the medical profession, but his advice on portfolio building applies to everyone. Start by deciding on what your financial goals and time horizon are, and then estimate the amount of money you will be able to put away per year. From there, a software program or online calculator can estimate the rate of return required to make this plan work.

Given the trouble many people are having in finding money to save and invest, the rate of return becomes critically important in determining whether you will meet your financial goals. Horton said his firm targets an ten-year annualized return of 6.1% before fees, based on a weighting of 57% in stocks and 43% in bonds and cash.

That's a typical asset allocation for balanced funds, which have been big sellers of late. If you're buying bond funds, which have been even bigger sellers, then you need to consider whether you're investing below your risk capacity, and thus putting yourself in a position to earn less than you need.

Don't be fooled by the investment results of the past five years. The benchmark for the bond market, the DEX Universe Bond Index, returned an annualized 6.9% for the five years to August 30, while the S&P/TSX composite index made just 0.2%.

Stocks are more likely to deliver a decent rate of return in the next five years than bonds, which have benefited mainly by a plunge in interest rates. If rates go any lower, it will be a close-to-inconsequential amount. Much more likely, they will rise over the five years to come.

It's not a crisis if your portfolio earns a low rate of return because it's invested conservatively. You can work around this by contributing more money or, if you're investing for retirement, you can work longer or scale back your intended spending once you leave the workforce.

An alternative is to ensure that you've got the right amount of risk in your portfolio today. Basically, that means establishing a proper weighting of stocks as well as bonds.

Can't bear the thought of your portfolio rising and falling amid endless waves of stock market volatility? "Focus on what your goal is, and what the time horizon is," Horton said.

"Year over year, we're going to see dramatic events in markets," he added. "It's going to happen. The nudge we're trying to give people is not to focus on short-term volatility."

Of course, there are times when it makes sense to be entirely or mostly in bonds or guaranteed investment certificates. "If our clients have less than a three-year time horizon, we say: Don't invest in equities," Horton said.

In practical terms, this means a parent with a child in the 10th grade would want to take a very conservative approach to investing in a registered education savings plan. Someone in retirement would want to have three years' worth of living expenses invested safely.

If safety is your goal, be sure that's what you're getting if you're a conservative investor. Bond funds—whether they're mutual funds or exchange traded funds—do not mature and return your capital to you like actual bonds or GICs do. This means that if interest rates start a gradual rise back to more normal levels from today's lows, bond funds will lose money.

So will individual bonds, at least until their maturity date. For nervous investors, GICs are a good option because they don't fluctuate in value like bonds or bond funds. The one negative is that you can't trade them before they mature.

As for those who are investing safely simply because it feels right, Horton suggests a rethink. "People who are buying fixed income right now—they're just not acting with all the information they need to make that decision."