Understanding Risk Vs. Volatility

In the past I've examined savings options for wise Canadians. I will briefly summarize what we have established so far.

Number 1: Most Canadians should always fill your TFSA account first. TFSAs not only give great tax benefits, they also offer fantastic withdrawal flexibility that RRSPs can't match.

Number 2: Fill RRSPs if you earn lots of money. Generally speaking if, individually, you earn more than $92,000 a year you should put every dollar over that amount in RRSPs until you can't anymore. In many provinces your marginal tax rate will be over 40% at this point.

Number 3: If you are serious about retiring early and have low expenses, put money in RRSPs. You can check out your provincial tax rates here; most provinces have a sizeable tax rate bump in the $65,000 - $80,000 range. Take advantage of RRSP contributions above these tax jump points.

Number 4: Don't ignore RRSPs just because you have a pension plan. It generally still pays to fill them after TFSAs as long as those RRSP accounts don't get too big and you retire early.

Number 5: Use Spousal RRSPs to balance retirement income. Two people withdrawing $30,000 a year each from an RRSP pay a lot less tax than one person withdrawing $60,000. Don't get fooled by bad financial advice telling you it's not necessary because pension income can be split. It's currently true for pensions, annuities and RRIFs, but this rule can be changed on a whim—always hedge against politics.

Got It, But I've Got More to Save

The next step is one of the great personal finance questions for home owning Canadians. Do I save in a taxable account, or do I pay off my mortgage?

To examine this question over the next two posts in this series, I am going to divide the Canadian population in this situation into two groups.

Group 1 will be those few Canadians who truly understand the difference between risk and volatility.
Group 2 are those who don't understand this, or those who understand but are simply debt averse (nothing wrong with that).

Plain Risky?

There are many different forms of risk analyzed in the financial world. Credit risk, operational (country) risk, and liquidity risk to name a few. Since we are not typically investing in low-grade debt instruments, invest only in easily traded broad index ETFs, and use Canadian (or possibly U.S.) stock markets, these forms of risk are not very prevalent. The risk we most often worry about is best known as equity risk.

Equity risk can include volatility, but if we separate it from volatility it can be simplified to the chance of your investment becoming worthless. This is why diversification and the use of ETFs is important.

For example, the iShares MSCI All-Country ex-Canada Index ETF (trades as XAW.TO) holds more than 5,500 stocks. There is a slim, but reasonable chance that one stock, like Royal Bank, might go to zero if there is a huge management scandal or house prices plummet to the point where RBC is underwater on their loan assets. It's realistically impossible for all 5,500 companies in XAW.TO to go to zero.

Oversimplified: broad index ETFs eliminate equity risk.

...or Just Volatile

Volatility, on the other hand, is very real for nearly all equities, longer term bonds, or high-yield bonds. Even diversified index ETFs fluctuate up and down considerably from week to week. It is not uncommon for a broad index ETF to climb or drop several percentage points in value in a week. They can also drop 50% in value over months.

But, just as reliably as they drop, they also go up. History tells us drops happen faster than climbs; however, the market climbs occur much more frequently than drops. Stocks, as a whole, go up year over year more than 70% of the time.

In the last 150 years, the 1930s Depression was the only time U.S. stock markets experienced consecutive annual drops. Every other time the stock market dropped more than 20% in one calendar year, the market climbed more than 20% the following year. Including the Great Depression, the U.S. stock market experienced >20% annual drops just 9 times in the last 192 years!

While index ETFs are definitely volatile, I would not consider index ETFs on their own to be risky. Incorrectly invested they might be risky when drawing income in retirement (sequence risk), using egregious amounts of leverage, or if the investor is likely to panic in a bad way during a market crash crystallizing those paper losses.

If you understand history, use your head, and stay invested, you can really benefit from a market crash!

On Friday I'm going to start with analysis for Group 2—the risk confused or debt-averse crowd—because it is easier to explain the next step for these folks.

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