Martin Pelletier: Investors are heavily swayed by whichever segment of the market is performing the best, even if the risk is high
One of the more important lessons I’ve learned over the years is that the value of a dollar is relative. Human psychology plays a huge role, often leading to emotion overruling logic. This is because money is used as a measure of fairness and so we make comparisons in the determination of its value.
A study by Solnick and Hemenway asked participants to choose between two options: A. You earn a yearly salary of $50,000 while others earn $25,000. Or B. You earn a salary of $100,000 while others earn $200,000.
Interestingly, half of the participants choose the first option, which makes no sense whatsoever. For many of us, we would prefer to live in a world where we earned half of what we could, as long as we were earning more than others.
A great real-life example is the recent emergence of the notion of “our fair share.” We have seen this over the past few years, via members of the public service or academia giving policy recommendations to the federal government advocating punitive tax changes affecting higher earners, including doctors or small and medium business owners.
The problem is that often in order to make a higher income, people need to take on risk that those making a safer but lower paying salary may not be comfortable doing.
When we look at investing, these notions of risk and comparison to others both play an important role.
This is the problem of benchmarking when it comes to investing. Investors are heavily swayed by whichever segment of the global market is performing the best, in spite of those fine print warnings that past performance does not indicate future results. Risk and reward are suddenly no longer part of the equation.
We find that the entrepreneurs have an excellent understanding of this relationship, having learned through direct experience. They have charted their own course independent of everyone else by setting their own individual targets based on their perceived risks weighed against the upside potential.
It’s no different when managing portfolios. We call this a “goals-based” approach, which means mapping out a specific target return required to meet the family’s financial needs, goals and objectives and then designing a portfolio to achieve it while mitigating the associated risks as much as possible.
Having already taken substantial risk in generating their wealth, we find many find this approach appealing and choose to accept a return that doesn’t involve full participation during market rallies in order to not fully participate in market corrections. Doing an investment review suddenly means looking at the performance with a different set of eyes by asking if the pre-set goals are being achieved rather than if they beat everyone else.
For example, in the old days when interest rates were much higher, it wasn’t uncommon to do a laddered Guaranteed Investment Certificate (GIC) strategy that would yield six to eight per cent. If this was even an option today, I’m sure it would encompass a large part of our portfolios given the nature of many of our clients. However, this would mean not allowing two back-to-back strong years in equity markets to influence our asset allocations, which can be a very tough thing to do.
Unfortunately, these days of high paying GIC rates are long gone, but the good news is that there are other vehicles such as structured notes that can achieve these targets, albeit with more risk than GICs but a lot less than global equities.
This doesn’t mean that by adopting such an approach there isn’t room for improvement. But we believe true success is not being better off than someone else but rather being better off than you used to be.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.
