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| Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, "Diversification is about being right more often than you're wrong.” |
By Ray Turchansky
Vancouver Sun
Special Report “Investing”
Wednesday, October 27, 2004
Modern portfolio diversification theory borne of chance meeting in 1952 but it's as applicable today as it was then.
Harry Markowitz was a University of Chicago economics and mathematics grad student in search of a dissertation topic in the early 1950s when he ran into a stockbroker.
As a result of his subsequent conversations, Markowitz decided to examine the relationship between the performance of various stocks, and discovered that if a person invested in different stocks that had a negative correlation -- when one went up in value the other went down -- it reduced the overall risk in a portfolio over time.
His Portfolio Theory of 1952 eventually became known as Modern Portfolio Theory, and in 1990 earned him a Nobel Prize in Economics, along with William Sharpe and Merton Miller.
The theory, now known as Asset Allocation, concluded that between 87 and 95 per cent of your investment returns will depend on which asset classes you are invested in. Only five to 13 per cent is a result of which stocks or mutual funds you pick and when you buy them.
They suggested the way to reduce risk by investing in stocks with negative correlations was by spreading out your investments among various assets -- equities, fixed income and cash.
Furthermore, within each asset class you should diversify -- by geography, by market capitalization and by sectors.
"Diversification is about being right more often than you're wrong," said Adrian Mastracci, president of Vancouver-based KCM Wealth Management.
As soon as Mastracci establishes a client's risk tolerance -- how aggressive or conservative they are -- he designs an asset allocation plan accordingly.
"When people first come in, quite often they're quite heavily into equities, like 80 or 85 per cent. But when you do their profile they probably wouldn't be comfortable with 60 or more. We generally have to cut it back."
The traditional rule of thumb for asset allocation has been to have a percentage of investments equal to your age in fixed income and cash.
However, people are now retiring earlier and living longer. Instead of having to fund 10 years of retirement income they now often have to fund 25 or 30 years, which means that even in retirement they have to grow their investments.
So, many advisers now suggest reducing your prescribed percentage of investments in fixed income and cash to your age minus 10, meaning a 40-year-old holds 30 per cent.
"The majority of Canadians would be okay with a mix of equities between 40 and 60 per cent," said Mastracci. "And in those equities you'd have stocks and mutual funds and ETFs [Exchange Traded Funds] and index funds. The other 40 to 60 per cent would be okay in fixed income -- some cash, some bonds, things that are more guaranteed."
Once you have decided on your asset mix, then you should look at diversification within assets.
One of the biggest moves is to invest globally. The Canadian economy generally makes up only two per cent of the world economy, and yet many people are far too concentrated on investing in their homeland
That's why it's advised to fully utilize the 30-per-cent foreign content allowed within your Registered Retirement Savings Plan.
"So many people who are not using the full 30-per-cent foreign content of the RRSP are missing out on the fact that there's a lot of good growth in the rest of the world," said Kate Warne, Canadian market strategist.
"It's better to diversify your portfolio internationally, as well as across industry groups."
Internationally means looking beyond the U.S. Europe presents opportunities, as do Japan and the emerging markets of China and India.
Or, you can look at it another way, taking into account both your registered and non-registered investments.
"For some people it may be more appropriate to have the foreign content outside your RRSP, but if you've only got an RRSP there isn't much choice," said Mastracci. "Quite often we put the foreign content elsewhere and leave the RRSP a little more conservative, depending on whether it's a replacement for a pension plan."
Equities should also be spread out by market capitalization.
Small cap stocks usually lead a recovery, while large cap blue chips offer security during market downturns, often through dividends.
Your equities should also be spread out among sectors. You should have some core holdings, such a financials, that generally have solid returns.
And they should be augmented with cyclical sectors, such as real estate, precious metals, technology or health care, though never more than 10 per cent in any one.
The argument is currently being made that energy and resource holdings are becoming core, rather than cyclical.
As for the fixed income part of your portfolio, bonds have had a great run for two decades and provided a great hedge during the bear markets of 2000-02.
Although their returns tend to fall during periods of rising interest rates, as we are embarking on, their demise hasn't materialized as soon as was predicted.
The suggestion is to ladder your bonds and guaranteed income certificates (GICs), which are staging a renewal, over various maturity dates.
Then, once you have your asset allocation and diversification plan in place, you must rebalance your portfolio at least once a year.
"We try to re-jig the ship when there's new money coming in or going out, so we don't trigger any more tax events than necessary," said Mastracci.
Different economic times may require moving in and out of some sectors. And your advancing age may mean getting out of volatile cyclical sectors altogether. It could also cause you to move into income trusts to receive a regular income stream, instead of having to sell off stocks or mutual funds to crystallize capital gains.
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