Financial Planning Before Investing

In a previous article, I attempted to clarify, what a CERTIFIED FINANCIAL PLANNER™ does. It was a long list of things including but not limited to helping people with cash flow analysis and budgeting, goal planning, debt management, insurance and risk management to protect your income and dependants, employer contributory pension plan or group RSP allocations, estate planning, taxes, career, life planning, college and university funding, buying a home, retirement projections and anything else that comes along. I went on to differentiate these activities from investment management. In my goal to separate these two very important but distinctly different activities, I may have left too big of an information gap and not been clear in how investing is dependent on financial planning. I left you hanging with “Certainly investment management is related to financial planning but is distinct from it. We believe strongly that investment management should not be commenced without financial planning.”

So, why do we believe strongly that investment management should not be commenced without financial planning? Well it has to do with risk. More specifically Risk Capacity.

If you made some investments through an advisor in the last decade or so, you have probably been asked to answer or fill out a questionnaire. It contained questions like – “When faced with a major investment decision, are you more focused on the possible losses or the possible gains?” OR “Investments can go up or down in value and experts often say you should be prepared to weather a downturn. By how much could the total value of all of your investments go down before you would begin to feel uncomfortable?” …and your answers were used to suggest a portfolio allocation to you. The bulk of the questions on these questionnaires are aimed at assessing your Risk Tolerance. In other words, they help your advisor assess how you will react to the ups and downs of the products or investments that you will purchase.

What is not determined from these questionnaires is your Risk Capacity. Risk Capacity is your financial ability to take on the risk. Risk as a concept is about exposure to uncertain outcomes. In investing, the common measure of risk is the volatility of the return experienced. The riskier an investment the more variable the returns will be. Risk Capacity can be thought of as your ability to accept variable outcomes. We can further narrow this down, by accepting that it is generally not a problem to experience too much return from our investments. The more the money, the merrier we will be. Therefore, from a practical sense, Risk Capacity can be thought of as your ability to accept negative returns of unknown size and frequency in the future. In purchasing terms, can you afford to take the risk?

If you are retired or near retirement, in order to determine whether you can accept future negative returns, it is necessary to evaluate when and what the returns will be used for. If you spend $60,000 per year and your pensions, CPP and OAS provide you with $60,000 or more, you could be considered to have an unlimited Risk Capacity as it relates to your portfolio. Since you do not NEED the returns, you have the ability to accept any and all future negative returns. However, if you spend $60,000 per year and your other incomes only provide $20,000 then your portfolio will need to consistently provide $40,000 per year. Negative returns in the future will impact your ability to maintain that $40,000 per year. Depending on how many assets you have and a host of other factors, your Risk Capacity could be very little or very great.

This is why Financial Planning is absolutely essential for retirees or near retirees. Unless your Risk Capacity is immediately determinable as unlimited, it is necessary to carefully evaluate your future spending and your future incomes from non-portfolio sources to determine your Risk Capacity. How can you build the proper portfolio to deliver the necessary funds as needed and at the right time throughout your lifetime, without determining acceptable future results and the frequency and size of negative returns? And it is not just any financial plan you need, it is a Cash Flow based plan that is required. Many advisors when asked to do some financial planning will perform a Goal-Based financial plan. Goal-Based planning will generally work well for younger accumulators. It will help determine what you need to do to get where you want to be and help you with what is necessary to get there. Its weakness in portfolio planning for retirees is that Goal Based planning will generally not provide a good Risk Capacity assessment of the negative outcomes. It will tend to report the Risk Capacity as the risk “necessary” to achieve the goals not the capacity to sustain the negative future outcomes.

If you are a retiree or near retiree, get a financial plan in place and stick to cash flow based planning. If you are young and building wealth, start with a goal-based financial plan and move to a cash flow based plan as your risk capacity declines. When you start accumulating, your risk capacity may not be unlimited but it tends to be very high.

So the next time your advisor asks you to just answer a questionnaire, ask them, “Is that it?”

Efficient Wealth Management Inc. was created to provide unbiased, independent, superior financial planning advice, on an Advice for a Fee basis.  Our extended mission is to bring portfolio manager services bundled with full financial planning to investors with zero to 2 million dollars.   We have been designing and utilizing strategic ETF portfolios for over 12 years, letting us return control of the cost of financial planning and investment management to the investor.

Gordon is a Chartered Accountant (CA), a Certified Financial Planner (CFP) and a Chartered Investment Manager (CIM).  He has close to 20 years of experience in Financial Planning and Portfolio Management and over 35 years in Tax Planning. Gordon is a frequent guest on television and has written numerous articles on investing and financial planning.   He has also taught Financial Services and Accounting courses at local colleges.