“Risk comes from not knowing what you're doing.” – Warren Buffet
A large part of my job involves providing information to employees who work for a company that offers a group retirement plan. I’m the person that they call when they need information about their group plan or help in choosing their investments. For many people, choosing RRSP investments is the one issue that gives them the most concern.
Given that the vast majority of people tend to be passive rather than active investors, it’s not really surprising that someone who doesn’t know a huge amount about investing, would be nervous about choosing from the long list of investment options that most plans offer. We’ve all heard stories about people who’ve “lost their shirt” in the stock market and, for a lot of people, the fear of choosing the “wrong” investment is very real. This fear is the reason why many people either procrastinate on completing their forms or leave the investment selection section blank, meaning that their contributions will be invested in whatever their plan’s default investment happens to be. Depending on the default, this isn’t always a bad thing, but my philosophy is that it’s always better to make an informed choice than have someone else make it for you. Here are three things to consider when choosing your RRSP investments:
1. Are You a Passive or an Active Investor?
How much do you know about investing? About mutual funds? More importantly, how much do you want to know about investing and mutual funds? For many people, the answers to these questions are “not a lot” and “not much” and this is one of the reasons why choosing RRSP investments can be so intimidating.
Investors tend to fall into two groups; passive and active. Active investors are people who love everything to do with investing. They’re “hands on” investors who like to read about investments, research them and learn about different investment strategies. They pay close attention to their own investments and enjoy managing them. Passive investors on the other hand don’t find investments especially interesting and so they prefer to take a more “hands off” approach, allowing others to take care of the investment management for them. Outside of Group RRSP plans at work, passive investors will often seek help from financial advisors when it comes to managing their investments.
When it comes to choosing mutual fund investments, there are funds designed for both passive and active investors. Knowing whether you want to take a hands-on or hands-off approach to investing helps you decide which funds are the best fit for you. If you’re a passive investor, look for Asset Allocation funds (which you choose base on your risk tolerance) or Target Date Funds (which you choose based on time frame). These funds are designed as a “one fund solutions” so that you can invest all of your money into just one fund that is diversified and managed for you. Balanced funds can also be a great solution for passive investors.
If you’re a more active investor, you would build a portfolio of 4-6 different funds and rebalance your portfolio once or twice a year. The percentage of fixed income and equity funds in your portfolio would be determined by your risk tolerance and time frame.
Related article: The art and science of rebalancing
2. What’s Your Time Frame?
Your time frame helps to determine how aggressive you can afford to be with your investment choices.
Related article: How much risk you NEED to take vs how much risk you WANT to take
In theory, the further away you are from needing your money, the more risk you can tolerate in your investments but this isn’t a hard and fast rule. Some people with plenty of time are very conservative investors and some people with short time frames choose to invest more aggressively. What’s most important is that you’ve made an informed choice and it’s one that you’re comfortable with.
Time is an especially important consideration for people who are close to needing their money because any downturns in the stock markets could reduce the value of their investments. Investors who are approaching retirement or who are planning to use their RRSP savings towards buying a home need to be particularly careful to choose more conservative investments that match their time frame.
3. What’s Your Risk Tolerance?
Your risk tolerance is the range of ups and downs you can tolerate in the value of your investments rather than the risk of “losing your shirt” in the stock market. Mutual funds allow investors to pool their money so that they can invest in a larger number of companies than if they were investing alone. These pools contain hundreds of millions of dollars and, on average, invest in 200-250 different companies. In order for a mutual fund to go bust, every company it invests in also has to go bust. So while the risk of losing everything in a mutual fund is small, there is a lot of variation in the highs and lows of different funds that makes it important to choose fund(s) that suit your stomach.
Related article: There's more than investment risk to think about
There are questionnaires you can complete to help you determine your risk tolerance but if you don’t have the time (or the inclination) for that, you can figure out roughly what your tolerance is by doing the following: First, think about risk on a scale of 0-10. Then ask yourself, if 0 is no risk at all and 10 is the type of investment that could make 30% in a good year and could also lose 30% in a bad year, where would you put yourself on the scale, between 0 and 10?
If you gave yourself 0 then guaranteed investments such as GICs or GIAs would suit you best.
- 1 or 2 = Conservative Investor (approx. 20% Equity and 80% Fixed Income)
- 3 or 4 = Moderate Investor (approx. 40% Equity and 60% Fixed Income)
- 5 or 6 = Balanced Investor (approx. 60% Equity and 40% Fixed Income)
- 7 or 8 = Growth Investor (approx. 80% Equity and 20% Fixed Income)
- 9 or 10 = Aggressive Investor (100% Equity 0% Fixed Income)
Related article: Model investment portfolios
Choosing RRSP investments based on your risk tolerance is important because, too often, people base their investment choices on past performance. They’re attracted to funds that performed well the previous year or which have averaged high returns over the past 5-10 years but they never actually look at the calendar year returns that show the highs and lows of the fund.
While it’s true that an aggressive fund might have averaged an 8% return over the past 10 years, in order to get that average, someone investing in that fund would have needed to be just as comfortable with that fund dropping 28% in 2008 as they were with it making 27% in 2013. If that range of returns is too much for your stomach; if you know that holding that investment in 2008 would have made you nauseous or tempted you to sell out and move your money into something that hadn’t dropped as much, then you don’t want to touch it with a 10 foot pole!
The financial services industry does an excellent job of making people feel as though they need a degree in business and a masters in math in order to manage their own investments. It's not true. If you're a passive investor, stick with the asset allocation and target date funds that are designed for hands-off investors. If you're more of an active investor, do your research, build a portfolio of 5-7 funds that matches your time frame and risk tolerance and rebalance once or twice a year. Stick with your plan through the ups and downs of the markets and you'll get to where you want to go.