Saving vs. Investing

What’s the difference?
Many of us have difficulty understanding the difference between saving and investing.  Both strategies are crucial for financial security and we are going to take this month’s email to outline our philosophy on saving, investing and designing portfolios.  Saving is done by reducing present consumption while the goal of investing is to increase future consumption through capital appreciation.  More practically, the difference between saving and investing is risk.  Savings are defined by having no risk of capital depreciation; this could mean bank accounts, specific low risk mutual funds, GIC’s and high interest savings accounts.  These tools should be used for emergency cash reserves as well as short term needs such as house down payments, new car purchases etc.  Most of us, in the hopes of increasing our disposable income or estate are comfortable assuming risk in order to earn returns that will outpace inflation.  Our job is to help our clients determine how much risk is appropriate for them to assume and help them choose the most efficient strategies and investments within a specific risk profile.

The first goal should always be to have sufficient savings.  Once a client has enough liquid savings to cover short term expenses and emergency funds, additional money can be allocated to an investment strategy.

Designing a strategy and portfolio for an investment plan

An investment strategy usually is divided into smaller plans predetermined for specific needs such as retirement savings or an estate.   The process we use for managing every plan in a client’s portfolio follows 7 steps as outlined below.

1. Determine goals for the plan and funding sources

a. Examples could be, plan will be used to deliver 6000 dollars per month (in today’s dollars) starting at the clients retirement in 12 years, or plan will be used to fund children’s education in 5 years.

2. Determine the clients risk profile for the plan

a. A risk profile for a given plan is determined by a client’s risk tolerance, a personal characteristic, and their risk capacity, a financial consideration based on what risks a client can afford to take.

b. For example, Mr. Smith, a skydiving instructor has a high tolerance for risk however; his retirement is now only 3 years away so his capacity for risk (or financial ability to suffer potential losses) is not as high. His risk profile for his retirement plan would be adjusted accordingly.

3. Using the goals and risk profile of the plan, develop a target asset allocation

a. Asset allocation, (the strategy of allocating funds between different asset classes) is responsible for 90% of a portfolio’s return. We, therefore, take great care in choosing class weightings.

4. Modify the target allocation to reflect economic conditions

a. As independent advisors we have access to the economic research departments of all the major banks and money managers in Canada.  We take advantage of these resources by adjusting our target allocations (within boundaries) to reflect leading economic opinion.

b. For example, Mr. Smith’s target bond allocation is 35%, however, all indicators and economist’s opinions suggest being overweight in bonds. We adjust by moving Mr. Smith’s bond allocation to 38% of his portfolio.

5. Note constraints within the portfolio

a. Examples of possible constraints on a portfolio include, tax consequences for non registered plans, a client’s desire to invest in only socially responsible companies, or a client’s desire to invest in a particular region of the world.

b. Constraints will also include other accounts the client holds. Investments must fit within the client’s comprehensive goals across all plans.

6. Choose investments that fit the asset allocation strategy, are wary of constraints, and will give the highest probability of meeting the goals of the plan while staying within the risk profile.

7. Monitor the plan and adjust for market variations (rebalancing) and changes to the risk profile.

Our research has shown that strategies that more actively try to manage money are not effective.  Market segment chasing strategies and market timing strategies among others do not outperform the market.  Our best tools and our strength at Redwood are working with clients to ensure they understand all of the risks they will face as investors and to appropriately judge their risk tolerance, and capacity.  The better we understand these factors the more effective we can allocate assets and efficiently invest your money.