Asset Allocation: Putting It All Together
An Introduction to Investment Planning – Part 8
Over the course of this series on investing, I have written about bonds and stocks and the ways they may be purchased, that is, individually or via funds, whether those are mutual funds or Exchange-Traded Funds. For now, I will wrap up this series with a discussion of asset allocation, which at its most basic is how you mix a combination of stocks and bonds to create an investment portfolio.
In my experience as an investment representative for DIY investors, I have seen many accounts that were: 1. Heavily concentrated in a small range of stocks; 2. A collection of stocks with no rhyme or reason to them; 3. All in GICs because they were unwilling to accept any volatility in their accounts; 4. Just sitting there in cash because they thought that someone was going to invest the money for them; or 5. Rarely, a simple, judiciously chosen, globally diversified selection of index ETFs or mutual funds.
Determining Your Risk Tolerance
Investments by their nature come with a degree of risk, as I wrote in an earlier blog post about common stock. How much risk can you tolerate? Traditionally, investment advisors have used risk tolerance questionnaires to get at this answer. These have some value but answering theoretical questions in a calm setting is very different than the reality of going through a precipitous market decline that has cut the value of your investments in half. Consider the S&P/TSX Composite Index, which was at 15154 in June 2008; in March 2009 it hit a low of 7480. As boxer Mike Tyson has reportedly said, “Everybody has a plan until they get punched in the mouth.” In other words, emotional and psychological factors are important. Even so, if you are interested, check out some questionnaires to see where you wind up on the risk tolerance spectrum:
In addition to diversification, which reduces the specific risks of investing in individual stocks, another benefit of investing in mutual funds or ETFs is that you can diversify your investments around the globe. The argument for seeking worldwide exposure is that you never know where your investment growth is going to come from. It may come from Canada, or the US, or perhaps from other developed parts of the world like the UK or Germany or Japan. It might even come from what are referred to as emerging markets: China, India, Brazil, South Africa, etc.
Canadian, US, developed international and emerging market indices, as well as bond funds, are all readily available for purchase through ETFs or mutual funds. The question is, how do you mix them up in order to meet your investment goals?
Strategic Asset Allocation
Let’s assume that, based on your tolerance for risk, your time horizon, and the required return to meet your financial goals, you decided that a balanced portfolio of 60 percent equities and 40 percent fixed income made sense for you. A table of your holdings might look like this:
|Asset||Allocation %||Expected Return %*||Contribution
to Portfolio Return %
|Expected Portfolio Return %||5.34|
These will not be the results you will get, although they are carefully calculated. The realities of volatility are that returns tend to deviate substantially from the long-term average. Nor do these expected results take into account any expenses, which could easily cut 0.5% from the 5.34% return presented here. However, 2019 turned out be a banner year for investing. Here are the results on a total return basis, meaning growth in the value of the security plus any dividends and interest that was generated in the course of the year:
|Asset||Allocation %||Actual Total Return %†||Contribution
to Portfolio Return %
|Portfolio Return %||15.21|
If you are interested in looking at some model investment portfolios, two sites I suggest are by colleagues of each other at a firm called PWL Capital. Dan Bortolotti runs the Canadian Couch Potato site. Here is the link to his page on model portfolios. Justin Bender runs the Canadian Portfolio Manager blog and also has a great section on model portfolios.
Investment analysts often talk about “return to the mean.” Essentially, if you hold these positions for the long term, there will be years where you get double-digit positive returns, like what happened in 2019, but there will be years when you may get double-digit losses, too. The overall effect is that your returns will, over time, give you the average (or mean). If only we could capture the good years and avoid the bad. Investors, including actively managed fund managers, may try to do that, but they seldom succeed. The best advice, it seems, is to stay invested in the markets, make sure that your portfolio’s strategic asset allocation is where you want it to be, and take the bad with the good.
This ends the current series of blog posts on investment planning. My next post will get into Insurance and Risk Management.
*The expected returns provided are derived from guidelines published by FP Canada, the certification body that issues the QAFP™ and CFP®.
†The actual returns results came from index-tracking ETFs managed by Blackrock, the owner of the iShares brand of Exchange-Traded Funds.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.