By Jim Houston, ICPP Funds Portfolio Manager

Our goal is to minimize our investors’ “risk of loss” over the long term. To achieve this goal, we aim to provide our investors the best expected long-term return relative to other asset classes. We believe this is most effectively realized through investing in the equity market.

The ICPP Accumulation Fund holds equity securities (“stocks”) in some of the largest and well-known companies in Canada and the U.S. These stocks are available to buy and sell daily, on regulated stock market exchanges.

Stock prices fluctuate continually and can sometimes swing significantly, both up and down. As such, some may assert that stocks are risky, making the ICPP Accumulation Fund inherently risky too. With an asset centric view, this assertion seems logical.

In addition to “risky”, given the recent run-up in stock prices, some investment advisors also claim that equities are too expensive relative to historical valuations. The recent price increases have been likened to a new round of “irrational exuberance” as expressed by former central banker Alan Greenspan, 25 years ago. That is, current stock prices make no sense from a fundamental valuation assessment. 

Any employer participating in a pension plan should ask themselves: “What is my risk of loss by investing in an equity asset class at this time?” This risk of loss should not refer to the loss of investment capital. Rather, it is the risk of failing to provide sufficient retirement income for employees.

Mitigating Risk of Loss within the ICPP Accumulation Fund

Even if the equities are supposedly risky and over-valued, stock investing has had the best historical long-term returns of any asset class. We also assert that it is prudent to continue to invest in the equity of sustainable companies looking to generate good long-term returns for its shareholders.

The ICPP Accumulation Fund invests all of its assets in the stocks of companies because we believe they are expected to achieve a better long-term return than any other asset class. This, however, is only part of the story. In order to reduce the risk of loss over our long-term investment horizon, we do not make investment decisions based on daily price fluctuations. We also employ risk mitigation strategies that reduce the Fund’s risk of loss over the long term. In fact, most of our risk mitigation strategies are structured to address the affects, at least partly, of irrational exuberance if/when it emerges.

Irrational exuberance usually occurs when too many buyers demand more of an asset and they bid up the purchase price of that asset to a point where the price is “irrational” (i.e. higher than common sense, or fundamental valuation would dictate). Too many buyers lead to inflated prices that can eventually become unreasonable. The process usually involves some hype and inevitably attracts new investors and speculators who fear missing out.

There are many examples of arguably over-heated asset prices in today’s asset markets, including; the real estate, gold, bitcoin, and equity markets. 

An investment manager realizes that when irrational exuberance emerges prices do not stop rising just because they are irrational. Irrational exuberance can last for a long, long time. There are always justifications for higher prices. It is not easy, and some would say impossible, to know when prices will top out. That occurs when the last buyer decides the requested price is too expensive and too many sellers emerge. A correction often happens suddenly and can be caused by an unforeseen shock, such as a pandemic. When too many investors want out of an overpriced asset, a price collapse occurs. There is a risk of loss in an irrationally exuberant market even over the long term. 

As portfolio manager for the ICPP Accumulation Fund, I ensure the implementation of two primary strategies that help reduce exposure to irrational exuberance.

First, the Fund must be very well diversified. It holds stocks in about 80 large, well established companies in approximately the same amounts. This matters because even when irrational exuberance emerges in an equity market, it does not emerge in the same way for every company’s stock price.

For example, during the late 1990’s Dot-Com mania, most of the irrational exuberance was piled onto internet e-company stocks.  As investors’ cash flowed into the equity markets chasing the internet dream, other companies’ stock prices benefited to a much lesser extent. By diversifying, we make sure that some of our stocks are not as exuberantly priced (i.e. have strong fundamental valuation).

Second, and just as important, the ICPP Accumulation Fund rebalances its holdings quarterly to maintain approximately equal weight for each company. This results in the sale of a company’s stock that has risen (i.e. could be inflated by irrational exuberance) and a purchase of a company’s stock that has not risen as much (i.e. less likely affected by irrational exuberance). This rebalancing arguably gives up a little of the potential upside but provides better downside protection. In other words, it lowers the risk of loss.

For a long-term investor, diversification and rebalancing are always essential. That is true whether the market is showing signs of irrational exuberance or is just plodding along. Our intention is not to eliminate short-term volatility. It is to provide consistent and reliable ongoing returns that meet our long-term goals, including providing sufficient retirement income for ICPP members.