Putting it All Together

Over the past few weeks, the investment team presented our Pathfinder mandate reports in lieu of our usual Pathfinder Investment Outlook (PIO). Each one of these reports provides insight into the state of the fund or portfolio, a look back at 2022, and thoughts around the year to come.

The purpose of today’s write-up is to explain how the recent reports and associated mandates are directly linked to your personal Pathfinder portfolio. In this report, we are shifting focus to your financial plan and how your portfolio is tailored to achieve your financial goals and objectives. The process of setting up a Pathfinder portfolio is thorough. We will breakdown the process of determining an appropriate asset mix, shed light on our portfolio construction approach, and dive into the steps of portfolio optimization.

Where We Start – Discovery

To begin, we look to determine a client’s financial goals and purpose of investing with Pathfinder. Generally, the purpose of investing is to commit money to earn a financial return and increase one’s wealth, but typically a client will come to the relationship with goals such as building wealth for retirement, saving for children’s education, and/or leaving an estate to loved ones, among many other potential objectives.

To understand our clients, we start the relationship with the discovery process. There are quantitative and qualitative questions asked during our initial discussions that uncover crucial information about our clients and their financial situations. This is also when we assess a client’s risk profile. It is important for us to clearly understand a client’s goals, what matters most to them, and any potential areas of concern. The goal of discovery is to begin establishing a relationship built on trust and to gain an understanding of who our clients are and what motivates them.

Investment Horizon

The timeline of financial goals is paramount in determining the strategy for the investment accounts. There are often some accounts within a portfolio that will have different goals and different time horizons. For example, a RRSP account is intended to help fund retirement, and a RESP account to help with a child’s post-secondary education.  The time horizon and risk of investment are related. The longer the investment horizon, the greater the risk can be taken as there is more time to recover. Short-term financial goals are best achieved with more conservative strategies.

Once the goals and purpose of the portfolio are established, we then look at a client’s risk profile. A risk profile is a combination of risk tolerance and risk capacity. There is also the risk of not taking enough risk, associated with risk requirements. Each is an important concept, warranting a closer look.

Risk Tolerance

All investments come with risks. Generally, the higher the potential return an investment offers, the higher the risk. But there is no guarantee higher risk investments will pay off with higher growth. Risk tolerance is related to the emotions involved with investing, essentially one’s willingness to tolerate risk. Portfolio fluctuation and volatility can often invoke an emotional reaction. This is often referred to as the “sleep factor”. The “sleep factor” boils down to the idea that if you are losing sleep over your portfolio then a conversative adjustment may be needed. An investor needs to be comfortable with the risk level of their investments.

Risk Capacity

Risk Capacity is one’s ability to accept risk or how much risk can be handled. Risk capacity is based on your wealth and your human capital (which is one’s ability to earn income from future endeavors). Typically, a wealthier household can afford to take greater investment risk because a potential financial loss won’t burden them as much as someone less wealthy. We always look at risk capacity on a holistic basis, ensuring we incorporate all assets and liabilities held by a client.

Risk Requirement

To achieve a specific goal, such as a desired retirement lifestyle, a minimum rate of return can be calculated. For example, consider an investor who needs to accumulate $750,000 by retirement in 10 years. This investor is only relying on growth within their portfolio. With $300,000 in the portfolio today and 10 years to grow it, the investor would need an average annualized rate of return of 9.6% to achieve the $750,000 goal. This 9.6% may require a riskier approach than what was determined by their risk tolerance and capacity. It is important to have clear expectations and disclosures of specific requirements. All three components of someone’s risk profile are interconnected and related. Risk profiles are dynamic, changing with the client over time.

Once a clear set of financial goals are in place and a risk profile is established, then we determine the appropriate asset mix. This is tailored to each client’s holistic financial position. The asset classes we select have different levels of associated risk and expected returns. Assigning specified exposure to different types of assets allows us to uniquely structure the path of returns to best meet financial goals. This is achieved by investing in different portfolio strategies.

Life is about Balance – Portfolio Construction 

Balance underscores the importance of avoiding uncompensated portfolio risks through diversification. Our portfolio construction framework fulfills the principle of diversification allowing us to position each client’s portfolio to preserve purchasing power as well as accumulate wealth. We evaluate clients’ assets from a unified household perspective to construct a portfolio without overlapping any investment strategies.

The strategic allocation can have a significant impact on a client’s investment success. Studies have shown that 93% of portfolio performance is dependent on the asset allocation of the portfolio; the remaining 7% was due to security selection, and investment timing (Brinson, Hood, & Beebower, 1986). In the developed markets of Canada, Australia, and the United Kingdom, between 80% and 90% of returns have been attributed to asset allocation (Wallick, Shanahan, Tasopoulos, & oon, 2012).

Taxes… Part of Life and Investing

Just don’t pay more than you have to.

We call this the tax optimization of your accounts. Once we come up with an asset mix that we feel will meet your financial goals, we look at all the various account types we have at our disposal to ensure we grow the account in the most tax-efficient way possible.

Clients come to us with various portfolio structures. For this report, we will use an example of an individual who is 50 years old and has a $500,000 investment portfolio. The portfolio is made up of a non-registered investment account, an RRSP, a LIRA from a previous employer, and a TFSA. We have determined that the client needs a balanced portfolio and has a medium risk tolerance. Detailed below is which Pathfinder mandate we will put in each account and why.

Non-Registered Account – $150,000

• Pathfinder Core North American – 100%
  • Dividends and capital gains are taxed favorably. This portfolio is made up of individual equities and the growth is going to come from dividends and capital gains. Therefore, we want to own this portfolio in any non-registered account.

RRSP – $250,000

• Pathfinder Fixed Income – 50%
  • Interest is taxed at your highest marginal rate and added to your overall income. Therefore, you want to shelter any fixed income investments inside your registered accounts to avoid paying tax at your highest rate.
• Pathfinder Core North American – 50%
  • We will own the Core North American portfolio in the RRSP in addition to the fixed income, aiming to achieve long-term growth.

LIRA – $12,000

• Pathfinder Funds – 100%
  • Given the LIRA is a small account, we will invest in the Pathfinder Funds, rather than directly into individual securities.
  • The client can’t touch this account until they are 55 years old, so it makes more sense to invest it for long term growth.

TFSA – $88,000

• Pathfinder Funds – 100%
  • Because the TFSA is a smaller part of your overall net worth and the growth is tax free, the TFSA should be invested as aggressively as possible to earn the highest potential rate of return, Tax Free.

When we look at the overall asset mix of the portfolio, it looks like this:

• 50% Blue Chip Equity (Pathfinder Core North American) – long term return target – 6-9%
• 25% Fixed Income (Pathfinder Fixed Income) – long term return target – 3-5%
• 25% Aggressive Equity (Pathfinder Funds) – long term return target – 10-15%

As the client nears retirement, we will likely adjust the asset mix to accommodate cashflow needs and the desire for lower volatility, by investing less into the Pathfinder Funds and more into Blue Chip Dividend paying equities in the Pathfinder Core North American portfolio and Pathfinder Fixed Income.

Pathfinder’s investment process is thorough and disciplined. We believe the same about of diligence and care that is employed through the investment selection process should be given to your financial plan and your portfolio structure. Financial plans are dynamic. The best plans are consistently reviewed and amended to reflect life changes.

For this reason, we reach out to our clients regularly to review and update any life changes or potential adjustments to investment objectives.  We treat this part of our investment process as a living document that is always updated. Many planners provide a static plan that does not change until the client reengages with the planner again. A fundamental part of our delivery is the continual update to the financial plan as life evolves. There are many variables that go into this process, and they are always changing: expenses, job situation, debts, health, investment return expectations can all change and materially impact a static document. There are many investment risks that the investment team at Pathfinder is managing everyday. The risk of mismatching portfolio construction against investor expectations is very material. This happens regularly in the investment industry (i.e., an advisor does not understand a client’s needs and goals properly, either from poor communication or lack of process). With regular contact, open discourse, and a regularly maintained investment management system, this risk can be minimized.