IN THIS ISSUE: With so many investment options available, how does one know where to put their money and get the best return possible? Sure we’ve all been told to stay ‘balanced’ and ‘diversified’, but what does that all mean? How do I know what to put into stocks, bonds or cash? In this edition of Tactics Planning Team member Howard Kwan breaks down the notion of asset allocation and shows us that the concept is, for the most part, a piece of cake.
Whether we know it or not, young or old, we practice a form of asset allocation in our personal lives. I recently had the pleasure of going to a family dinner outing and accompanied my eight-year-old nephew, Nathan, through a buffet. Excited and confident, with an empty plate in his hand, his eyes were filled with an assortment of food choices. He had a variety of salads, a mountain of freshbaked breads, three different main entrees and various side dishes. You get the picture.
Even my nephew knew that when you’re at a buffet, you don’t fill up on just one thing. Of course I had to steer him away from the desserts as a start, but he knew to take reasonable portions of each item and to leave room on his plate for a variety of things.
This is the same idea for investing. In the investment world, this is called Asset Allocation. Let’s grab a dinner plate and get started.
So what is Asset Allocation and why is it important?
Asset allocation typically involves three categories: cash or cash equivalent; stocks; and bonds. When you have money to invest, you “allocate” a portion of your money in those asset classes.
Different market conditions can cause an investment’s value within those asset classes to rise and fall and, historically, the returns of these three asset classes have not moved together. In fact, market conditions that result in one asset class doing well, often results in another asset class underperforming.
Here’s an example. In 1999, Emerging Markets had an average return of 59.93%, Foreign Equities had a 20.05% return, and who could forget U.S. Technology with a 90.58% return. Canadian Bond market had a lack-luster -1.14% return.
The following year, Emerging Markets were down -27.79%, Foreign Equities were down -10.46% and U.S. Technology was down -34.26%. Canadian Bonds, however, were up 10.26%. There are numerous examples of similar situations throughout market history. By including different asset categories, investors can protect themselves against significant losses when market conditions change.
The importance of asset allocation lies in creating a portfolio which will have one area doing well when another is not. This can result in a portfolio that has less volatility by mitigating investments that drop in value with investments that go up. The objective is that over the long term, the entire portfolio is generating a reasonable rate of return.
In fact, studies have shown that 90% of investment performance is due to asset allocation, as opposed to market timing, securities selection or hiring the best portfolio managers (source: “Determinants of Portfolio Performance II: An Update”, Financial Analysts Journal; May/Jun 1991″). The asset allocation that’s best for you at any particular point in time depends on your current personal circumstances and your comfort level with risk.
The relationship between Time Horizon and Risk Tolerance
Typically, someone with a long investment time horizon can accept more risk in their portfolio, because they know that they are willing to ride out the various short-term ups and downs in the market for a potentially better rate of return over the long term. They know they can achieve a particular financial goal when they reach a certain point in time. A shorter time horizon usually means you can’t afford a loss of your capital, because you do not have time to wait for the investment to recover.
A person with high risk-tolerance needs to understand that if they choose one investment over another, they stand a chance to making several times more money. They also must realize that there’s a risk of losing some, if not all of their original investment. A conservative investor not willing to lose any of their capital will have to accept the fact that they face a lower rate of return. This is the concept of Risk versus Reward.
These two areas are inevitably connected — the greater the risk, the greater the potential for a larger reward (and vice versa). Keep in mind that if you do not include enough risk in your investment mix, your portfolio may not earn enough to keep up to inflation or meet your financial goals.
What is Diversification and why is it important?
The term ‘diversification’ is often described as “not putting all your eggs in one basket.” Asset allocation, which is a form of diversification, is in itself not enough when building an investment portfolio. A diversified portfolio should be diversified between asset classes and within asset classes.
Diversifying between asset classes is simply what I’ve mentioned earlier (cash, stocks, bonds, etc.). Diversifying within an asset class means that you select a group of investments representing that particular asset class. So for a bond portfolio, you might want to hold bonds with various maturity dates that have been issued by different companies of various sectors (municipal, provincial, federal governments, corporate). For a stock portfolio, you might choose 50 stocks instead of just five stocks.
How do money managers try to achieve the right balance between Asset Allocation and Diversification?
In 1952, an economics student at the University of Chicago named Harry Markowitz published a doctoral thesis called Modern Portfolio Theory. Markowitz’s theories won him a Nobel Prize for Economics in 1990 and his research continues to influence how money managers approach investing to this day.
His thesis became the basis for the efficient frontier (as depicted in this graph below), which shows how various portfolios maximize expected returns at various levels of portfolio risk. The x-axis (horizontal line) represents risk and the y-axis (vertical line) represents expected return. As portfolios are plotted on the graph, a curve shape starts to develop.
This is how the efficient frontier was created. Analysts looked historically at thousands of different portfolios representing cash, stocks and bonds with various percentages and plotted them based on historical returns and risk. (Risk is measured by standard deviation, but for the sake of simplicity I won’t go into details on how this is derived.)Source: http://investor.verisign.com/common/glossary/5659.gif
The top end of the curve represents high-risk portfolios which have higher potential return (High Risk/High Return). However, many portfolios may have the same degree of risk, but the returns differ.
For example, Portfolio A and Portfolio B (represented as blue dots on the graph) have the same amount of risk, but different potential rates of return. A portfolio manager would, of course, choose Portfolio A which offers you a higher potential return versus Portfolio B which has a lower return with the exact same amount of risk.
In other words, managers attempt to build a portfolio that, given a certain level of risk tolerance, provides the maximum possible expected return that falls on the “efficient frontier.”
Adjusting and Rebalancing
When a portfolio manager rebalances a portfolio, they are returning it to the original asset allocation. The reason for this is that over time some investments move away from the intended allocation. Rebalancing the portfolios ensures that the investments inside do not represent too much of a particular asset class. For example, equities increase in value faster than bonds. Therefore, if you don’t rebalance the portfolio, over time you would have too much exposure to equities.
When is it the right time to adjust the actual asset allocation? In other words, when would you go from a 60% equity exposure to 40% exposure? One reason might be because you’ve reached retirement. Most people investing for retirement gradually reduce the amount of equities inside their portfolio and hold more bonds and cash equivalent investments at retirement. So changing an asset allocation strategy usually occurs when there’s a change in lifestyle or financial situation.
I cannot stress this point enough: asset allocation is based on personal circumstances, not market conditions.
Note that I did not mention changing asset allocation based on the performance of an asset class. In other words, an investor should not buy more of a particular stock because that stock is doing well. Therefore, a prudent investor would not typically change their asset allocation based on how well a particular market does. However, this is exactly what some investors do when they start making changes to the asset allocation of their portfolio based on market swings.
What most advisors do with a typical “balanced” portfolio
Most traditional money managers have a fairly narrow universe of assets to choose from. An allocation of 60% equities (Canadian Equities, Foreign Equities, small cap, etc.) and 40% bonds (Canadian Bonds, Foreign Bonds) is quite typical for clients of traditional money management firms. However, just because a portfolio has various types of mutual funds, stocks and bonds, does not mean that portfolio will avoid volatility.
At Nicola Wealth Management, we believe in giving our clients access to a broader range of investments that generate cash flow. These include income trusts, annuities, bonds, convertible securities, dividend- paying common shares, income-producing real estate, and mortgage investment pools. This results in an asset mix that would be quite different from that of a typical money manager.
Having underlying cash flow helps keep the value of a portfolio from falling as much as the market itself. We adhere to a long-term balanced investment approach and we believe in a consistent investment philosophy of broad diversification. Having predictable cash flow will help ease the majority of short-term portfolio volatility worries. Investments such as real estate, mortgages, and hedge funds have low correlation to most stocks (see sidebar on correlation).
Our track record has shown that this strategy results in lower volatility in our portfolios and better risk adjusted returns in the long run.
So the next time you’re at a buffet allocating food onto your plate, think about how you allocate your investments. Granted, some buffets are better than others because they may have fancier food, bigger selection or better ingredients, but a buffet is a buffet: they all still offer soups, salads, side dishes, entrees and desserts. Asset allocation is taking reasonable portions of each delectable course.
Diversification, on the other hand, is like making sure you eat a good variety of fruits and vegetables. Was I harping when I told my nephew to make sure he eats all his carrots and broccoli? Sure, a potato is a vegetable, but no matter how you slice it, dice it, mash it or fry it, it’s still only potato and probably not the best item to load up on.
As far as adjusting and rebalancing is concerned, that double chocolate layer cake with butter cream frosting looks really great, but maybe I should think about rebalancing to a smaller piece. After all, I did have that cookie at lunch and I want to set a good example for Nathan.
Besides, the last thing I want to be readjusting is my belt.