No one can achieve long-term investing success without a well-thought-out strategy and clear objectives. The starting point is asset allocation. So this week, I begin a series of articles on how to develop an asset allocation approach that will provide the balance and consistency needed to ensure above-average returns over many years.
The first step in the process is asset class selection. There are four basic types of assets in every investment portfolio. They are:
Cash. This consists of currency and highly liquid cash-equivalent securities such as Treasury bills, money market funds, and Canada Savings Bonds. Any asset that can quickly be converted to cash for its full face value qualifies as "cash."
Fixed income. These securities pay a specified (fixed) rate of return and have a maturity date, at which time your principal is returned. If they are sold or cashed in before that date, the result may be a loss or a penalty to the investor. Bonds, mortgages, fixed-rate preferred shares, and GICs fall into this asset class.
Variable income. In years past, this was not considered to be a separate asset class but times and markets change. A variable-income security offers cash flow on a predictable basis (usually monthly or quarterly) but the amount of the payment is not guaranteed and may vary considerably. These securities may or may not have a maturity dates. Examples include floating-rate preferred shares and income trusts.
Growth. Assets in the growth category add value mainly through capital gains. Stocks and equity mutual funds are the most common examples.
There are several factors to consider in deciding how much of each asset class to hold in a portfolio. They include your age, your time horizon, your tax situation (if it is a non-registered portfolio), the economic climate, your risk tolerance, etc.
Generally, the higher the percentage of cash and fixed-income securities in a portfolio, the less risky it will be. However, the trade-off is that the profit potential will be reduced. The more variable-income and growth securities you have, the greater the chance that you will achieve above-average returns. But you will also expose yourself to greater losses during periods when the stock market is in decline or when interest rates are moving sharply higher.
This is what makes the decision difficult. You have to weigh these considerations and decide where you want to place your portfolio on the scale. If you choose to be ultra-conservative, you need to reconcile yourself to the fact that the value of your portfolio will likely grow more slowly. If you decide in favour of growth, you must be ready to accept the ups and downs of volatile stock and income-trust markets.
I recommend that you start from the position that you will include all four asset classes in your portfolio. I have heard ultra-aggressive investors say: "To heck with that. Stocks are where the action is, and I'm going to put all my money there." Interestingly, I have never heard anyone use that argument during a severe market slump, only when a bull market is in full flight. When stocks drop dramatically, as they did in 2000-2002, the brave suddenly turn timid.
The real danger in choosing an all-growth portfolio at the outset is psychological. Suppose you had made a decision in late 1999 to load up with high-flying technology stocks or mutual funds? By the time the bear market came to an end in October 2002, the Nasdaq Composite Index had plunged 88 per cent from its high point! There is not an investor in the world who could deal with that without a great deal of psychological trauma. Not only will it take a long time to recover from such a heavy loss, but anyone who experienced it may have been left with mental scars that will never heal.
So use all the asset classes. No zeros for any of the four. Rather, it's a matter of deciding how the distribution will be made.
Cash is normally allocated the smallest percentage in an investment portfolio because of the low return it generates. But there are two reasons for holding some. First, cash is the safest asset you can possess in difficult times. Second, a cash reserve allows you to take advantage of opportunities in the stock and bond markets that may appear. If you don't have any cash, you'll be forced to sell something else, which you may not want to do at that moment.
The minimum cash holding in your portfolio should be 5 per cent. The maximum should be 25 per cent and that would only be reached under very unusual circumstances, for example during a period when short-term interest rates are high and the stock and bond markets are slumping. These conditions do occur from time to time, the early 1990s being the most recent.
The percentage of fixed-income assets will be governed by two main considerations: your risk tolerance level and the outlook for interest rates. Under normal conditions, fixed-income securities carry much less risk than growth securities. So a portfolio that is weighted towards bonds and GICs will be less volatile than one that holds only a small percentage of such assets. In fact, certain types of fixed-income securities, particularly bonds, have the potential to generate above-average returns during periods when interest rates are falling so this can be another factor in your allocation decision.
The range of fixed-income securities in a portfolio can vary from as low as 20 per cent to as high as 50 per cent depending on the circumstances. Generally, an allocation in the 25 per cent range is adequate.
Variable-income securities are trickier. These are most often used to generate cash flow after retirement, but there is a place for them in a younger person's portfolio as well. The weighting should gradually increase as you grow older.
Growth securities should receive the largest allocation share when you're young, gradually diminishing as you approach retirement. The minimum allocation should be 25 per cent and you would be at that level only during full-blown bear markets or if you are approaching, or past, retirement. The maximum weighting for growth securities is 70 per cent.
Even people who are retired should retain a portion of their portfolios in growth securities as protection against even modest rates of inflation, say 25 per cent. You don't want to outlive your money!
