Feeling Rich Can Make You Reckless

When my husband and I went to our bank to see how much of a cottage we can afford, I was floored (and somewhat freaked out), when our friendly neighborhood banker came back with the number. Not even in my wildest dreams would I ever borrow that much money. Even scarier was that the bank said we could!

Now, let me explain something. My immediate family is far from rich. Rather, we belong to comfortable middle class, make decent money, and have almost zero debt to our names. These days, it seems, what we thought was middle class, financial institutions have reclassified into something much less realistic. Perhaps the pursuit of fees and commissions has something to do with it, but that is a story for some other time.

Over the last few years, real estate and stock markets have inflated much more than anyone thought would be possible. Such asset appreciation was fuelled by almost a quarter of a century of declining interest rates. No doubt about it, being on the long side of assets over a long-term investment horizon has resulted in massive capital growth.

Of course, investing for the long term, weathering market ups and downs, is what real investors do anyway. But this capital/asset appreciation had one more result: an inflated feeling of being rich. And it couldn’t have come at a worse time — when interest rates are done declining and we can expect lower returns in the years to come.

Of course, it is in our nature to still try and pursue those high returns of not so long ago. In doing so, however, investors are likely to recklessly hike up their risk tolerance. You see, it is one thing to be willing to take on more risk; quite another to be able to. My bank might be willing to take on more risk by giving me a ludicrously high line of credit, but I don’t think I’m able to carry it.

Yield on the safest investments in Canada — government treasuries — is at about four percent. To calculate the expected rate of return on capital, we use something called the Capital Asset Pricing Model (CAPM). The CAPM calculation needs two more variables: the overall return on the market — which is likely to be in single digits — and the market’s risk measurement, or beta. In any event, once we plug in all the numbers into the CAPM formula, the only way those expected returns will go up is if investors take on more risk.

In the months and years to come, I’m sure your bankers and brokers will try to convince you to buy more assets and stocks. If I were you, I’d make sure you have done your own CAPM calculation before buying more real estate via equity loans, or speculative stocks in pursuit of higher yields.

You don’t have to know the formula. The only variable in the equation that you have some control over is your own ability to take on risk. Remember two things: first, taking on more risk when investing for the long term (more than 10 years) historically makes sense, provided your risk tolerance level has been estimated realistically at the onset; second, your willingness to take on more risk is not the same thing as your ability to take on more risk. If you feel richer following such a long, secular bull market in asset and capital trading, that does not necessarily mean you actually are richer.