By Arnold Machel, CFP®
"I, wisdom, dwell with prudence, and I find knowledge and discretion.”
Proverbs 8:12 (ESV)
It’s an interesting anomaly that when the word “investing” is used, some equate it with saving while others’ thoughts immediately go to gambling or speculating. My suspicion (from many, many client interviews) is that this has more to do with one’s past experience than with any sort of misunderstanding of the definition of the words. Whether their first investment experience (and/or subsequent ones) were speculative investments or prudent ones typically colours their view of what the word “investing” means to the individual.
Factually, investments can be either. Whether speculative in nature or prudent in nature, there is a vast difference between the two, yet both can fall under the heading of investments — much like acid and milk are vastly different, yet both fall under the category of liquid.
Speculating tends to result in either losing big or winning big. Prudent investments, while not guaranteed and still somewhat volatile, are highly unlikely to create catastrophic loss of capital and are highly likely to accrete in value over time. That doesn’t mean there is anything inherently wrong with speculating. It’s just important to understand which you are doing. A retiree placing all of their investment portfolio into something speculative would be a bad idea, whereas a 20 year-old placing their entire $1,000 net worth on a good bet might not be so bad.
So what makes the difference? In part, it’s the underlying investment, but in part (and maybe that is why it’s so confusing for some people) it’s how they are put together. A small portion of a prudent portfolio might be invested in something speculative, but if it’s just a small portion and it’s placed within a handful of “solid investments” then the whole portfolio would still be considered prudent.
The clear majority of high quality (prudent) portfolios that I look at have a number of similar characteristics:
- They consist of a mix of stocks and bonds (or mutual funds that invest in them).
- They are diversified geographically (usually with a home country bias followed by a home continent bias).
- They are then further diversified by investment styles (growth vs. value) and by company size (large company vs. small company).
On the other hand, speculative investments tend to be in high risk areas and often with little or no diversification. For example, a few months ago a potential new client came into my office and told me she had about $500,000 “invested” in gold mutual funds which she wanted us to start managing for her. This represented her entire portfolio. That’s speculating – pure and simple. She owned gold mutual funds, so at least she had diversity of companies, but each one of their fortunes was tied to the price of gold, so her portfolio will go up and down based almost entirely on the vagaries of the gold markets. She’ll make a bundle if gold goes through the roof, but conversely will see a huge decline should the bottom fall out. In this particular case, since we don’t deal with speculative portfolios she was surprised to hear that not only was I not comfortable with the risk she was taking on, I would not consider taking her on as a client unless she was willing to be more conservative.
Another client once pointed out to me that he had $150,000 in Telus shares at another firm. This was in addition to the $400,000 he had invested with me. Is that speculating? Maybe not, but it’s starting to border on it. After reviewing his volatility comfort level and comparing it to the past volatility of his existing investments vs. the volatility of the Telus shares he decided that having such a large portion of his assets in one company presented too great a risk and he trimmed the position. Would he make more money keeping the Telus shares? Only time will tell. We do know that it’s likely that he would either make a lot more or lose a lot, so the decision wasn't about which would make more – rather it was about how much risk he was willing to take on.
Typically, a prudent portfolio will earn you a reasonable rate of return over time and will protect you from catastrophic loss of capital, but (and this it critical to internalize) it will still experience periods of negativity. Sometimes significant ones. Prudent portfolios can range from conservative to aggressive, but will never be speculative.
A more conservative portfolio will tend to have fewer periods of negativity with those periods also being less severe, but with the downside being a lower return. It would typically hold a larger percentage of fixed income and a lower percentage of equities (ownership of companies) than a more growth oriented portfolio.
A prudent, growth oriented portfolio would tend to be one comprised primarily of equities, but still be well diversified and properly managed. By owning many companies in many regions, you can be protected from catastrophic loss (a company or two might go bankrupt, but it’s virtually impossible that all of them do), but you won’t be protected from temporary broad market declines.
Within the context of prudent portfolios, an aggressive well crafted portfolio of great companies is likely to earn substantially greater returns than a conservative one, with the downside of more frequent and more severe down turns. Both remove the risk of permanent loss of capital, but the conservative one is also much more stable.
One of the most important (probably the most important) decision that you can make with regards to your investments is what that asset allocation should be. Whether you want to be conservative, balanced, aggressive or speculative is something that you (and your adviser) should put a great deal of emphasis on. This decision will hinge on many factors such as your age, ability to handle negative financial events and simply your comfort level with volatility. Don’t take it lightly. It will determine both how well you sleep at night in the short term and how good your return is in the long term.
Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at firstname.lastname@example.org or through his website at www.visionvest.ca. Please note that all comments are of a general nature and should not be relied upon as individual advice. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.