DECEMBER 29, 2010
I was inspired by a recent BMO press release to revisit the topic of asset allocation and building an investment portfolio.
The press release notes that the majority of Canadians do not have a combination of short and long-term financial goals. I can't help but feel that some of the other popular finance and economics blogs don't do enough to educate people on the need for several portfolios with several different purposes. I've noticed that the advice often amounts to "buy a preferred share since it yields a tax-advantaged dividend", but with no mention of the appropriateness of this investment for different time horizons. That's what this post will partly be about.
Before I even discuss these portfolios, let me first say that if you are carrying credit card debt or other consumer debt, by far your best bet is to pay that off before you consider creating one of these portfolios. You will never match the risk-free rate of return you'll get by paying off a credit card balance. Kill that debt before you think about creating an investment portfolio.
Every household needs at least two different portfolios. Many will need three or more.
Let's start with the two that all households need.
1) Emergency fund
Every household needs an emergency fund equal to at least three months of living expenses, with six months being even better. There is only one place where this 'portfolio' should be invested: Cash in a readily available savings account. PC Financial, Canadian Tire Financial, ING, etc all pay at least 2% on their deposits in a high interest savings account. It's not sexy, but it is something that everyone should have. If you are trying to prioritize, I would put the emergency fund directly behind paying off credit card debt in order of importance.
A neat website that compares interest rates on various high interest accounts can be found here.
2) Retirement portfolio
There's a lot of thought that needs to go into building a retirement portfolio. It is something that many people may want to seek professional advice for. If you are willing to do a bit of legwork yourself, consider using a fee-for-service financial planner to help you get the portfolio initially set up, and then maintain it yourself.
By far the biggest part of creating your retirement portfolio is selecting an appropriate asset allocation. Well over 90% of the return on your overall portfolio will be due to asset allocation as opposed to individual security selection.
Basically, asset allocation is simply the percentage of your portfolio that will be invested in different asset classes. The two most basic asset classes are stocks and bonds. From there, things can be made as complicated or as simple as you like.
Stocks can further be broken into domestic stocks, foreign stocks, emerging market stocks, small cap stocks, large cap stocks, preferred shares, and real estate investment trusts (REITS)...among others.
Bonds can be broken into domestic bonds (short and long duration), real return bonds, foreign bonds, and corporate bonds...among others.
In addition, you can add other asset classes like precious metals and commodities.
I know it sounds really confusing, but it's not actually that bad. You can create a winning investment portfolio by selecting an appropriate asset allocation and then matching it with ETFs or mutual funds that match the desired allocation.
Creating your asset allocation
Two factors must be considered when creating your asset allocation: Time horizon and risk tolerance.
Time horizon is fairly simple. It simply considers how many years you have to invest before you need the money. Someone who is 25 should have a very different portfolio than someone who is 60 simply because one needs the money sooner and therefore can not prudently take on as much investment risk.
As a very rough guideline, the percentage of your portfolio that should be invested in safer investments like bonds and cash should be equal to your current age. We'll tweak this in a moment to also reflect your risk tolerance, but for now, it's a pretty good rule. Not considering risk tolerance, the 25 year old should have 25% of their portfolio invested in bonds, while the 60 year old should have 60% invested in bonds.
Risk tolerance is the tricky one. We tend to overestimate our risk tolerance, which can be an expensive mistake. Many people who thought they had a high risk tolerance, found themselves selling at the depths of the market crash in 2009. You don't want to do that. You want to create a portfolio that will have an overall volatility that you are comfortable with so you can weather the downturns without doing something rash. Bonds (particularly short term bonds) and cash tend to have very stable, predictable returns and smooth our volatility over time. But they also tend to reduce the overall profitability of the portfolio over a long enough time horizon.
Stocks, on the other hand, tend to be quite volatile relative to bonds, but they also tend to outperform cash and bonds over time. So it's a bit of a tradeoff. Big, well established companies (often called 'blue chip' companies) tend to be less volatile than smaller companies, but for now we'll consider stocks as one distinct asset class. In the investment world, risk and return are inseparable. Any time someone tells you they can get you a risk-free rate of return significantly above the current deposit rate, they are flat-out lying to you. Period! You may be able to get a few percentage points above the deposit rate with low risk, but much more than that and you are embracing some more significant risk to achieve those returns. Be VERY hesitant to hand your money over to anyone who makes promises to achieve high returns with little risk.
While the 25 year old mentioned above may consider having 25% of their portfolio invested in bonds, they may want to increase or decrease that percentage based on how comfortable they are with overall volatility. If they are okay with seeing their portfolio drop a couple percent in a day where the stock markets sell off, they may want to decrease their bond exposure. If they would panic and sell their stocks during such a sell off, they should decrease their stock exposure.
If you simple google the term 'investment risk tolerance questionnaire', you'll find plenty of sites that will help you determine how risk tolerant you are. As a very basic rule, if you are extremely risk tolerant, you may want to reduce the bond/cash portion of your portfolio by 25%, while if you are very intolerant of risk, you may want to add 25%, with the remaining range falling in between these two extremes.
So, the 25 year old who is extremely risk tolerant may want to consider an all stock portfolio, while the 25 year old who is extremely intolerant may want to consider a 50-50 mix. Just remember that risk and return are tied together. All things being equal, the all stock portfolio should be worth considerably more in 40 years when retirement time comes around.
Creating a basic ETF portfolio
Once your basic stock/bond or risky/safe asset allocation is created, it's time to fine-tune the portfolio.
Fine tuning the bond portfolio:
A pretty decent bond portfolio can be achieved by simply splitting your bond exposure into short-term bonds and real return bonds in an even split. If you have 40% of your portfolio invested in bonds, consider allocating 20% to a short-term bond fund or ETF and 20% to a real return bond fund or ETF. It's a rough split, but it will do the trick. For the short-term bond exposure, consider and ETF like XSB or CLF. For the real return bond exposure, consider XRB. If you want to play around with the asset allocation, you could throw 5% in a corporate bond ETF like CBO.
Fine tuning the stock/riskier portfolio:
Here's where things get tricky. Because of the generous tax laws associated with owning Canadian stocks, they should represent a good chunk of your stock portfolio. Here is a VERY basic break down of the stock exposure you may want to consider, with a couple ETFs that represent them:
40% Canadian stocks (XIC)...You may want to go 30% XIC, 5% REIT (XRE) and 5% preferred (CPD), but both REITS and Preferreds are also captured in XIC, which is a broad market ETF
15% precious metals (PHS.U, PHYS.U, SBT.UN, CEF.A)
15% US stocks (XSP)
15% International stocks (XIN)
15% Emerging market stocks (XEM)
NOTE: Vanguard offers some great ETFs that trade on the New York exchange. They are worth looking in to for US, international, and EM exposure. I stuck to the Canadian ETFs for simplicity sake. I understand that they are all currency hedged, which is of questionable benefit.
There you go. An excellent portfolio with just a handful of ETFs. You can rebalance annually or as you have new money to invest.
If you are just starting out in the investment world, you will find that investing in stocks and ETFs may not make sense since the transaction cost to buy and sell your investments will eat up a significant portion of your money. Instead, I would suggest you use no load mutual funds to create a basic portfolio. Even better, go to TD and set up an e-fund account. From there you can build a good portfolio using only their e-funds.
Use their bond fund for your total bond exposure, their S&P500 fund for the US exposure, their Canadian equity fund for your Canadian/precious metal exposure, and their International Equity fund for your international and EM exposure. Once that grows to at least 10K, consider moving it to a discount brokerage like Questrade and make the ETF purchases.
In the next post I will address how to build additional portfolios such as a house portfolio to be used in a couple years. I will also give you some tips and rules for individual stock selection, as well as some tips on finding a good mutual fund company.