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Gen Y Money Our kids got RESP money for Christmas. How should we invest it?

Question e-mailed in from Globe reader: We have a family RESP in an online brokerage account for our sons, aged 8 and 10. For Christmas, their awesome grandparents have given each of the kids $1,000. That, combined with our contributions, means we have $4,000 in cash sitting there now. We have topped it out each year, putting in $2,500 per kid, and invested the money over time in a number of index-tracking ETFs. We have seen gains of around 18 per cent since we opened the RESP. But we are nervous about stock markets going forward. Everything feels uncertain, stocks seem due for a pullback. Should we pull our older son’s money out of equities and put them into something safer such as GICs? Or should we invest again, and if so, what would you recommend?

Answer from Benjamin Felix, an associate portfolio manager with PWL Capital in Ottawa.

The only constant in financial markets is uncertainty. That is no more or less true today than it was yesterday, and it will not change tomorrow. Finding the perfect time to invest is next to impossible to do consistently; market timing is notoriously hard to get right. Any time that you have money to invest, the best time to invest is right now.

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Ben Felix helps Canadians invest their money, and writes about it at csinvesting.ca.

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This is true regardless of what the market is doing and what the news headlines are saying. As true as that statement is, there is an important caveat. Right now is only the best time to invest if you are investing in a risk-appropriate portfolio. What is risk-appropriate depends on a handful of factors. In short, your portfolio needs to be aligned with your time horizon and your psychological tolerance for volatility.

If we assume that your children will enroll in postsecondary education at age 18, then it may feel like you have around eight and 10 years before needing these dollars. One thing that people often miss with the RESP is that you do not have a hard deadline to withdraw all of the funds when the child enrolls in school.

The only requirement for a tax efficient RESP withdrawal is enrolment in postsecondary education. At enrolment, an initial withdrawal of up to $5,000 can be made. After enrolment for 13 consecutive weeks, the remaining RESP assets can be withdrawn for up to six months after enrolment in the program. For a four-year program, this might give you nearly five years after the children have started applying for schools to withdraw the money.

Of course, if the money is genuinely needed to fund education costs the time horizon will coincide with enrolment. The point is that depending on your circumstances, you may have some flexibility in your time horizon for the RESP assets.

Once you have figured out the time horizon that you’re comfortable planning for, you are equipped to think about what a risk-appropriate portfolio might look like. In general, a shorter time horizon would suggest lower exposure to stocks. The reason for this is that the likelihood of losing money in stocks decreases over longer periods of time.

In the 2013 book Playing the Winner’s Game, Larry Swedroe suggests maximum equity allocations based on different time horizons. If we assume that you will need this money when the children are 18, your maximum suggested equity allocations would be 70 per cent for your eight-year-old and 50 per cent for your 10-year-old.

With that in mind, one of the words in your question that stood out to me was “nervous.” A 70-per-cent equity portfolio is all well and good, but if it keeps you up at night, or worse, results in you selling at the bottom of a market decline, it may be too aggressive. In his book, Mr. Swedroe also suggests maximum equity allocations based on your personal level of comfort with potential market declines.

After looking at both these two exercises you should tend toward the lowest maximum equity allocation of the two. For example, if the 70-per-cent equity exposure associated with a 10-year horizon makes you feel faint, then you would tend toward an equity allocation that you can live with. It is important that this decision is not made based on how you think the market is going to do over the coming months or even years. You need to consider how much risk you are able to take based on your time horizon, and then adjust that based on your long-term preferences, not your short-term predictions. It seems sensible to me for you to maintain some equity exposure for now based on your time horizon. Going all-in on GICs with eight years to go could have a substantial opportunity cost.

Now that you have a risk-appropriate portfolio, the most sensible thing to do is invest the $4,000 that you have sitting in cash as soon as possible. Waiting for the right time to invest is more likely to make you worse-off than better off for two main reasons: The market cannot be predicted, and you’re more likely to gain than lose by the cash being invested sooner rather than later.

In a 2012 paper, Vanguard looked into the most common metrics used to estimate future market returns and found the Shiller CAPE to be the most accurate. In the data used for the study, the Shiller CAPE explained 43 per cent of the difference in future returns over 10-year periods. Forty-three per cent is impressive but it leaves 57 per cent of future returns unexplained. Betting on something with less than 50-per-cent historical accuracy is not something that I would call sensible. Far more concerning for a would-be market timer is the fact that while the Shiller CAPE has some explanatory power over 10-year returns, it has almost no explanatory power over one-year returns. Put simply, even the most useful market timing metric that we know about is completely useless for deciding whether you should invest today, or wait until next month.

Knowing that we can’t time the market, many people take the approach of dollar cost averaging – investing smaller amounts each month. In your case, it might mean investing $400 a month for 10 months to avoid the regret of investing a lump sum right before a market decline. In another 2012 paper, Vanguard compared dollar cost averaging to investing a lump sum and found that lump sum outperformed dollar cost averaging in about two-thirds of historical samples. We know that your best expected outcome comes from investing in a lump sum, but if that makes you nervous then I see no issue with dollar cost averaging over some period of time, preferably less than 12 months. In the grand scheme of things the difference in your ultimate outcome should not be material.

The last thing that you want to do is change your asset allocation or hold off on investing new money for predictive reasons or feelings of uncertainty. As long as you have an asset allocation that makes sense for you, the best thing to do is maintain exposure to that asset allocation for as long as possible. If investing a lump sum makes you nervous, then dollar cost averaging into a risk-appropriate portfolio over a pre-determined period of time is a great option.

I would not pull everything for your older son out and put it into GICs based on how you’re feeling about the market. You should make sure that the portfolio is sensible based on the approximately eight-year time horizon for your older son, but other than that I would not make any drastic changes. As you get closer to the end of your planning horizon for each child you will adjust the portfolio toward a more conservative allocation.

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