If Canadians knew that the stock market was certain to go up by 10% over the next few years, would they bother to hold 3%-yielding Guaranteed Investment Certificates (GICs) or Bonds in their portfolios? Probably not! American billionaire, hedge fund manager and investor extraordinaire Raymond Dailo (who founded one of the largest hedge funds in contemporary times – Bridgewater Associates), once said:
You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.
Think of your portfolio as the proverbial “basket”, and the various classes of assets held in that portfolio as representing “eggs”. Asset allocation is the conscious distribution of your invested capital (in your “basket”) amongst various types of assets (your “eggs”). When it comes to strategically allocating assets (eggs) across a portfolio (basket), good investment practice dictates that you shouldn’t hold just a single type of asset in the portfolio. Instead, allocate your investment dollars to a range of assets. Why?
Because, in case a single class of assets doesn’t perform well over a given timeframe, you are likely to do better if you also held other asset types in that portfolio. That way, if one asset (egg) falls and breaks, others will remain intact to deliver you the portfolio returns that are looking for. Notice the word “likely” being stressed in the above paragraph? Well, that was done intentionally! Smart portfolios are constructed to not leave much to chance (“likely”) events. And that’s where strategic asset allocation comes in. While good asset allocation helps you avoid putting all your eggs in a single basket, strategic asset allocation invests in asset classes based on your personal circumstances.
Deliberate asset allocation
A couple of decades or so ago, the asset allocation rule of thumb was: Subtract your age from 100, and then invest that much (as a percentage) of your nest egg in equities. The rest of your investments would be spread into Bonds, GICs and other fixed-income instruments. So, a 40-year old would have 60% equities in their portfolio, while a 60-year old would have 40% allocated to equities.
Well guess what? That formula does not work anymore – and here’s why:
- Firstly, on the average, Canadians are living much longer today than 20 or 30 years ago. So, for a 60-year old investor to allocate only 40% (100 minus 60) of his/her portfolio into equities makes no sense – especially if the remaining 60% is yielding returns that are barely above inflation.
- Secondly, what we said above – that if 60% of your non-equity portfolio is barely keeping up with inflation, how will you live off your portfolio for the next 35 or 40 years? That’s just not possible!
Today’s wealth managers therefore don’t embrace cookie-cutter asset allocation formulas. They might start off with an asset allocation loosely based on the 100-minus-age formula (perhaps substituting 100 with 110 or 120!). But they then construct deliberate asset allocation plans that are uniquely tailored based on the individual investor’s personal circumstances.
And what might those circumstances be? Great question – so let’s explore it in detail.
Asset allocation building blocks
Just as no two individuals are alike, so too, no two portfolios should be constructed identically. That’s why asset managers allocate assets to a portfolio based on each investor’s profile. Some of the characteristics of that asset allocation profile include:
- Your age: Generally speaking, younger investors can afford to allocate more capital to slightly riskier assets. Why? Because in the event of a market down-turn, you’ll have many years ahead of you to let your portfolio recover those losses.
- The size of your portfolio: The smaller your portfolio, the less diverse your assets might be. For instance, if all you have is $5,000 – would you be comfortable risking it all on volatile stocks? Probably not! Your best bet would be to invest it all in a super-safe money market fund.
- Your investment time-horizon: The closer you are to drawing-down your portfolio, the less risk you want to take. If you have a one to two-year investment time horizon, then your portfolio should be heavily tilted to less riskier assets – e.g. money market funds, GICs or annuities.
- Your risk tolerance: The greater your risk appetite, the more capital you can allocate to riskier assets like equities.
- The expected rewards from allocated capital: Smart asset allocation is definitely about protecting your capital. But it is also about earning a decent return. So, if a 5-year GIC promises you 2.75%, and a slightly riskier asset (A+ credit rated Canadian Corporate Bonds[i]) is yielding 3.4% then, because of the risk-reward proposition, it makes sense to allocate some capital to the bonds.
So, when you put all of these pieces together, you could end up with a well-diversified portfolio, with assets allocated between:
- Stocks, bonds, and alternative assets
- A mix of equities across industries and sectors of the economy
- Stocks of small, mid and large-cap companies
- Equities across a broad segment of the globe, from Canadian, U.S., Asian, European and Emerging economies
Spreading out your portfolio to include all of these different asset classes, based on the profile characteristics discussed earlier, is what strategic asset allocation is all about. But like all other advice in life – there are exceptions!
Finer asset allocation considerations
If you stick with the asset allocation building blocks discussed earlier, you should have a pretty well-diversified portfolio that will help you grow and preserve your wealth. However, you might not need to worry about too broad an allocation if:
- A significant portion of your future needs will come from a “guaranteed” company Defined Benefits Pension plan; or
- If you expect to meet most of your retirement expenses from the Canada Pension Plan (CPP) or other government income programs; or
- You already have a significant piece of your portfolio allocated to long-term fixed income investments that are guaranteed to provide you with income sufficient to cover all your needs.
A well allocated portfolio means that you don’t need to worry about short-term ups and downs of the market. It also means that you won’t need to be overly concerned if some assets perform poorly for a short time. That’s because smart asset allocation is also about ensuring that your assets aren’t closely correlated. For instance, if you buy and own all of the house-hold tech companies in your portfolio – Apple, Google, Facebook, Twitter, Shopify – you might feel your portfolio is well allocated, but it’s not! Buying a lot of socks doesn’t make for great asset allocation. As Tony Robbins, the prolific and exuberant performance coach once said:
The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation
The best way for Canadian investors to ensure they have a portfolio of well allocated assets, is to work with a wealth management company who truly understands their needs and is committed to creating personalized portfolios just for them.
If you have further questions about asset allocation send us a message through our contact form.