A Primer on Asset Allocation

What is “asset allocation” and why is it important?

Asset allocation is a term for describing how much of each investment class you should have in your investment portfolio. John Heinzl of The Globe & Mail says that asset allocation is related to the concept of diversification – “the idea that you should spread your risk across different investments so you won't be overly exposed to a downturn in one particular area”. In other words, don’t put all your eggs into one basket!

Unfortunately, many investors forget all about asset allocation – until it's too late! That was painfully obvious during the market collapse of 2008-2009, which blindsided investors who had devoted too much of their portfolios to stocks. For those near retirement, this would have been disastrous.

Investopedia.com, an excellent resource for investors and students, says:

“There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make … In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.”

The process of determining which mix of assets to hold in your portfolio is highly subjective and there is no obvious right answer. What will suit you best any given point in your life will depend largely on two main factors:

1. Time Horizon. Your time horizon is the expected period of time (months, years, decades) that you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a down payment on a house would likely take on less risk because he or she has a shorter time horizon.

2. Risk Tolerance. Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. It is important to remember that all investments involve some degree of risk and that your reward for taking on investment with higher risk is the potential for a greater investment return. Any decent investment advisor will typically ask you to fill out a questionnaire to assess how well they would react in a severe market decline and then design your portfolio accordingly.

Investment Classes

A vast array of investment products exists - including stocks and stock mutual funds, corporate and municipal bonds, bond mutual funds, lifecycle funds, exchange-traded funds (ETFs), money market funds, and treasury securities. For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let's take a closer look at the characteristics of the three major asset categories, by order of most risk to least risk.

1. Stocks and Equities. This asset category has historically had the greatest risk and highest returns among the three major asset categories. The volatility of stocks makes them a very risky investment in the short term, but investors that have been willing to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns.

2. Bonds and Fixed Income. Bonds are used by companies, municipalities, and various levels government to finance a variety of projects and activities. Bonds are generally less volatile than stocks but offer more modest returns. The two principal determinants of a bond's interest rate are credit quality and duration. Also, keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.

3. Cash and Equivalents. This category includes such as savings deposits, GICs, T-Bills, and money market funds. These are widely considered the safest investments, but offer the lowest return of the three major asset categories. The principal concern for investors investing in cash equivalents is inflation risk (the risk that inflation will outpace and erode investment returns over time).

It should be noted that in addition to the three main asset classes, some investment professionals would add real estate, precious metals and commodities to the asset class mix. This will be the topic of future postings on this blog.

Asset Allocation Models

Here are some general “asset allocation models” that are designed to help investors and advisors in categorizing their preferences. These are largely goal based (i.e. buy a house in the next 6 months, retire by the age of 60, etc.) and many financial firms typically will provide funds and portfolios along these lines.

1. Capital Preservation. This is for investors who intend to use the money sometime in the near future or who would lose sleep if their portfolio went down even a few percentage points. This is not really an “investment” as it usually sits in a savings account or some short-term guaranteed investment such as government bonds or 30-day GICs. The goal is to protect your capital, earn a very small amount of interest (desirably at or above the rate of inflation), and liquidity for when you need cash in hand.

2. Income. The income portfolio is designed for those who need the income from their investment. It usually is retirees but could be anyone who needs the income from their investment for any purpose. The majority of the investments are in income generating vehicles such as government and corporate bonds, Income Trusts and quite often large dividend paying companies. The investor that utilizes the income model is typically a retiree and not concerned with growth, but wants capital preservation and the safety of income.

3. Balanced/Income-Growth. Probably the most common model used is the balanced model and pretty much anyone can fall into this category as it provides somewhat more stability. A simple portfolio of this type would have 60% in stocks and 40% in bonds. This model aims to provide a level of capital protection as well as growth opportunities.

4. Growth. This is a more aggressive model and its main goal is to provide capital appreciation with no or little income. A typical growth investor is a young employed individual who is looking to increase their net worth and do not care much about income or capital preservation. Types of investments held in here are mostly growth stocks (ranging from 50-80% of the total portfolio) and maybe some small portion in dividend stocks and high-yield bonds.

5. Aggressive/Speculative. This is the most risky model and not many investors fall in this category. I think this model resembles casino gambling as this type of investor is in for the quick buck. Types of investments are small start-up companies, IPOs, or companies in some type of distress where the outcome is very uncertain. There generally is no fundamental or technical analysis and is based on “gut feelings”.

To help you decide what kind of investor you are and the asset mix appropriate for your situation, here are the links to a few online calculators to try out:

·        http://www.smartmoney.com/calculator/investing/managing-asset-allocation-1304479164310/

·        http://cgi.money.cnn.com/tools/assetallocwizard/assetallocwizard.html

·        http://www.bankrate.com/calculators/retirement/asset-allocation.aspx

·        http://www.money-zine.com/Calculators/Investment-Calculators/Asset-Allocation-Calculator/

For fun, try them all and try to see where they differ and where they agree.

Other Strategies

I’ve come across a few interesting alternative strategies with regards to asset allocation. The first one I will discuss is called “lifecycle investing” which basically advocates that you “diversify across time”. The argument is that traditional asset allocation does not give you much growth when you are young and have a long time horizon with a relatively small portfolio – so this type of investor should put ALL of their available funds (including borrowing money to invest) into equities. The investor will gradually move into 100% fixed income portfolio by retirement. While theoretically sound, I am personally uncomfortable with young investors “putting all their eggs in one basket” and leveraging their portfolio to magnify returns as it leaves the investor vulnerable to not having enough cash on hand in case of emergencies.

Another interesting investment strategy that I recently came across was while reading Nassim Nicholas Taleb’s 2007 book titled The Black Swan: The Impact of the Highly Improbable. Taleb argues it's possible to ward off “black swans” using a "barbell" method that consists of “taking both a defensive attitude and an excessively aggressive one at the same time, by protecting assets from all sources of uncertainty while allocating a small portion for high-risk strategies”. In other words, barbell strategies typically involve balancing your investments between two extremes. In this case Taleb recommends putting 80% of your assets into relatively stable investments (i.e. government bonds and GICs), and the remaining 20% in risky securities like stocks and commodities.

Some Final Thoughts

One of the most important things to remember is that overtime your asset mix will shift. Your stocks may outperform your bonds and this will shift your original asset allocation so every ones in a while you will have to do what is called a rebalancing of your portfolio to bring it back to its original goal allocation. I strongly recommend that at least once a year you review your investments and your financial goals and decide which strategy is the most appropriate for you.

The Financial Pyramid – Assessing Where You Stand

So, you’ve been watching BNN constantly and you think you’re ready to start investing your hard-earned money in penny stocks and IPOs? Do you have an updated Will and proper insurance coverage? Have you started an RRSP? Are you struggling with credit card payments? Is the answer no? Then forget it!

Before undertaking any financial venture, you must have a good strong base from which to work to successfully reach the goals and objectives that you’ve set.

One tool that I came across while I was taking the Canadian Securities Course (CSC) that will help clarify your current situation and identify planning needs is the “financial planning pyramid”. Although the financial planning pyramid may appear simplistic, I can attest that is it a useful visual aid and used by many financial advisors. The financial planning pyramid helps to visualize your long-term goals and objectives and review your overall investment strategy.

(Source: CSI Global Education Inc., Canadian Securities Course. Vol.2. 2010. ch.26., p.11. Print/eBook.)

The remainder of this post will look at the foundation of the pyramid – “Security” and “Independence”.

The very bottom of the pyramid looks at protecting those closest to you from unavoidable risks (death, sickness, accidents, job loss, etc.) of which you can normally cover with insurance policies and wills. When it comes to insurance, I am not an expert and likely not too many of you are either. In which case, it might be prudent to find yourself a reliable insurance broker that will help you get the best insurance policies at the best possible price.

At the next level, you should identify the debts you now have or those which you are assuming day by day. For these your plan should include the reduction of these debts if they are now, or likely to be a problem in the future. Personally, I believe that any debts that you have that are on items that depreciate (i.e. car loans, consumer products, etc.) should be considered “bad debt”, while anything debts on appreciating items (i.e. a house or an education) is a “good debt”.

Next, you should start a Registered Retirement Savings Plan, or RRSP. What is an RRSP plan, you ask? RRSP is a personal savings plan that is registered with the Canada Revenue Agency which allows you tax shelter your investments. Any growth within your RRSP plan is tax deferred, not taxed until withdrawn, at which point it is taxed as an income.

RRSP was put in place to encourage Canadians to save for their retirement and lessen the burden on the government when Canadians retire. The idea is that throughout your working years you save a portion of your income in the RRSP plan and upon retirement you start withdrawing from it to supplement your CPP and OAS income. This is probably going to be more important now that the Federal Government has now proposed as part of their budget to increase the age of eligibility from 65 to 67 years old.

Any contribution you make to your RRSP account is tax deductible, you will get a tax refund based on your marginal tax rate. Generally your tax bracket would be lower after retirement, so you would be paying less tax while growing it tax free.

You should note that in your RRSP account you can hold variety of investments, such as a savings account, GIC’s, mutual funds, bonds, equities, gold or silver bullion and many more. However, I would advise you to place interest bearing investments into your RRSP account as it is more tax efficient since it will be tax deferred and place dividend stocks in your non-registered account where you can benefit from the dividend tax credit.

Finally, you should establish an “emergency fund” of cash in a high interest savings account or some other liquid investment (i.e. Canada Savings Bonds) which will address the risk of loosing your job or some other unforeseen circumstance. This should typically cover at a MINIMUM at least three months of your current wages.

My motivations

I recently took a look at the financial statements of a close family member to determine when would be the earliest date that they could retire. Much to my surprise and dismay, most of this family member’s investments were only marginally generating yields better than 91-day Treasury Bills (typically considered the safest, but one of the lowest returning investments in the market) and, more disturbingly, this poor relative did not know why.

In other words, I would like to help increase people’s “financial literacy”, which was defined by the Task Force on Financial Literacy as: “having the knowledge, skills and confidence to make responsible financial decisions.”

More precisely, I would like to share some key skills and knowledge that I consider necessary to make informed and educated decisions about your budget and your finances. However, I should note that reading my blog will NOT qualify you to be a professional day-trader anymore than any blog can make you qualified to be a brain surgeon (and no, I am not comparing traders to neurosurgeons!). I would like to equip you with questions and mental tools to go out into this crazy market and help you avoid some of the pitfalls and traps that have caught so many people.
Also, I am fully aware that the term “financial literacy” is somewhat of a loaded term. According to Barry McKenna of The Globe and Mail, there is no evidence that financial literacy leads to better financial outcomes, calling it a “smokescreen”. I am actually in agreement with Mr. McKeena on this point in that “financial literacy” is being used by the Government of Canada while simultaneously shifting the financial burden from government to individuals. This blog is a product of this experience. My goal is to address what economists call “information asymmetry” – what can be generally defined as a situation in which one party in a transaction has more or better information compared to another and can be harmful because one party can take advantage of the other party’s lack of knowledge.

Saul Schwartz, professor of public policy at Carlton University points out that the federal Task Force for Financial literacy is headed by the CEO of Sun Life Financial and the Chairman of BMO Nesbitt Burns – likening them to “foxes in charge of the chicken coup”. This is valid, as anyone should be wary of anyone wanting to “educate” them – especially when there’s money involved.

So, to be clear, I think “financial literacy” should be though of as a toolkit and a critical (or sceptical) approach with dealing with financial professionals (like myself), economists, politicians, and the like. It should be used in conjunction with an social activist approach were we put pressure on government to put more stringent requirements on the size of mortgages and credit lines, be way more clear about interest rates paid and fees charged on financial products, and having financial statements and prospectus’ written in plain English.

Phew! With that, I hope you enjoy my insights and let me know what you think – I love to hear about your insights, experiences and questions.