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By Susan Heinrich
Canadian Investment Guide 2005
It’s easy to lose sight of your overall goals if you don’t have a clear strategy. Here’s how to keep on track.
A young professional in her early 30s, Holly Matthews* is disciplined in almost every aspect of her life. She works hard in her management position with a communications company, takes extra courses in the evenings and still finds time to exercise three times a week. She pays her bills on time and has been a diligent saver since she opened her RRSP at age 27. She set up her retirement fund through her bank branch and selected a portfolio of six funds, with her money spread among a variety of asset classes: money market, global bond, two Canadian equity funds (one with a value management style), a global equity fund and a specialty resource equity fund.
Adrian Mastracci, ‘fee-only’ investment counsel at
Vancouver’s KCM Wealth Management, says, "Look upon diversification as welcome protection. You don’t want problems arising in any one asset class to ruin your well-crafted portfolio. So it makes good sense to spread your nest egg across a variety of investments."
“I chose an aggressive growth portfolio, based on my long-term objectives. It was heavily focused on equities, and I was comfortable with it at the time,” she says. It worked well – for a while. But as some funds significantly outperformed others and she kept adding new money to the portfolio, it became hopelessly out of line with her original investment goals.
Five years later, she has almost half of her portfolio idling in a money market fund and significant weighting in a high-risk precious metals fund that has jumped in value following the technology meltdown in 2000.
“It was always in the back of my mind that I should be revisiting it, especially whenever I made RRSP contributions,” she says. “But I didn’t. It became very unbalanced.”
Matthews admits she found it difficult to make decisions when markets were so turbulent. And, as a result, she has made one of the most common mistakes in investing: ignoring her portfolio’s asset allocation. To do that is to miss out on a remarkable opportunity, says Gordon Garmaise.
“If you combine [funds of] different asset classes, economies, currencies, industries and risk levels, something magical happens,” he says. “The risk of the package can be significantly less than the risk of the individual assets on their own.“ Garmaise defines asset allocation this way: ”It is engineering a combination of assets best to provide exposure to return and minimize exposure to risk.”
To invest your money without an asset-allocation strategy is kind of like going on a car trip without a map or directions. You will eventually arrive somewhere, but it is unlikely to be exactly where you intended to go. And chances are you probably took a few detours along the way. How big of a role the right allocation plays in achieving the result is a matter of dispute in the financial community. But whatever the number, experts agree, the proper asset allocation will give you an investment edge. And regularly rebalancing your portfolio back to that ideal allocation will keep you there.
The roots of asset allocation stretch back to the 1950s, when Harry Markowitz, a graduate student at the University of Chicago, decided to apply mathematical methodology to the stock market. He published a groundbreaking paper in 1952 entitled “Portfolio Selection,” in which he presented the idea that it was possible to create portfolios with an efficient frontier.” His research, along with that of William Sharpe and Merton Miller, led to modern portfolio theory (now known as asset allocation) and the three were awarded the Nobel Prize in economic sciences in 1990.
Markowitz figured out that diversification improves results because some investments perform better than others in certain economic conditions, so by selecting investments with varied risk and return characteristics, investors can improve performance.
“Diversification and rebalancing are fundamental investment tools,” says Adrian Mastracci, an investment counsellor with Vancouver-based KCM Wealth Management Inc.
He advises clients on every aspect of financial fitness, from tax planning to portfolio allocation and individual investment selection. He explains the importance of asset allocation this way: “Look upon diversification as welcome protection. You don’t want problems arising in any one asset class to ruin your well-crafted portfolio. So it makes good sense to spread your nest egg across a variety of investments,” Essentially, it’s investing’s equivalent of not putting all your eggs in one basket.
Mastracci encounters many clients for the first time who, despite their best intentions, are missing our on the benefits of proper asset allocation. “I had a client come to me with $1.2 million in the markets and 27 equity funds, nine fixed-income funds and a cash account,” he says. “She had three advisors, and none of them knew the whole story. I can’t even keep track of 27 equity funds. How could she?”
The explanation as to why so many investors find it difficult to maintain an appropriate asset allocation lies in human psychology, says Ena Garmaise. She has spent the past 10 years researching investor attitudes and behaviour. Her findings indicate we’re actually hard-wired to commit common investment blunders, such as buying the latest hot-performing fund.
“Investing is a very uncertain but important activity. We all have trouble handling uncertainty,” she says. And that’s why we look to recent experiences for guidance.
“If we look at our history our forebears, who were foraging and hunting, had a very good reason for going back to where they went yesterday. We’re hard-wired to overweight recent events,” she says.
That proclivity was the downfall of many investors whose portfolios rode the technology boom all the way to the top in 2000 and then free-fell along with it down to the bottom.
“Selling winners and buying losers – that’s very difficult to do, psychologically,” says Ena Garmaise. “It goes against the grain, and that happened in the [technology] boom. People didn’t realize how risky their portfolios were when they had those huge run-ups. You look at the Nortel [Networks Corp.] phenomenon: people found it very hard to sell.”
It is clearly advisable to get the right asset allocation and stick with it, regardless of market ups and downs. But before investors even begin to look at individual mutual funds for their portfolios, they should do two things: complete what is known as an “investor profile” and clearly define their investment goals. A professional advisor can help you with both. All mutual fund salespeople – whether at banks, brokerage firms, mutual fund dealers or discount brokerages – should take you through what is known as the “know your client” process before they sell you a fund. In fact, provincial securities laws require it.
In defining investment goals, you need to ask yourself a number of questions: how long will the money be invested for? Is the portfolio for retirement 20 years away, or for a down payment on a cottage five years from now? As well, understand how much risk you are comfortable with and make sure you are aiming for a realistic rate of return, given that risk tolerance. You may find you don’t have to take as much risk as you thought if you are comfortable with a lower rate of return. Conversely, once you set out your savings goals, you may decide you are willing to take more risk to achieve them. By having these goals set out ahead of time, it becomes easier to stick with your plan and rebalance as needed to stay on track.
Investors who want to go through part of this process themselves can determine their risk tolerance at the Ontario Securities Commission’s investor education Web site: www.investored.ca. The site offers what it calls an investor profile self-test” that includes seven multiple-choice questions. The answers to those questions will provide investors with a suggested asset allocation appropriate to their risk tolerance.
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