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Each portfolio contains a recommended weighting for various asset classes. For example, investors with a low tolerance for risk would be recommended a portfolio with 10% of their assets in speculative investments, 30% in moderate-risk investments, 40% in low risk and the balance, 20%, in cash and equivalents.
To explain better where investments fit in on the risk spectrum, the investment industry uses an “investment pyramid” to categorize choices. Those considered “speculative,” such as emerging market equity funds, would be slotted in at the top of the pyramid. Low-risk ones, such as money market funds, sit at the bottom. The higher the investment in the triangle, the higher the potential return and the higher the risk. In other words: in good times, the funds at the top can be blockbusters; in down markets, their losses can be dramatic.
Examples of different fund types and where they would fall in the investment pyramid include high-yield bond, aggressive growth equity, small-cap equity and some sector funds in the speculative group. The moderate risk group includes blue-chip equities, Canadian and international large-cap stocks and royalty trusts. In the low-risk group are bond funds and mortgage funds. And, finally, sitting at the bottom of the pyramid are cash and equivalents such as money market funds.
For investors who take the OSC’s investor profile test and score in the mid-range, an appropriate portfolio has less cash than the risk-averse portfolio cited above – 10% vs. 20% - and more speculative investments, with those weighted at 20%. The weighting of the other two categories are reversed from the first example – moderate risk funds would account for 40% of the portfolio and low-risk funds at 30%. And, finally, investors willing to take more risk in exchange for higher possible gains are recommended an asset allocation of 30% speculative, 50% moderate risk, 10% low risk and 10% cash equivalents.
But as is seen in Mathews’ experience, starting out with the right asset mix doesn’t guarantee success. The other half of the equation is rebalancing the portfolio at least annually to keep the various asset groups at the optimal weighting for your portfolio.
“I recommend rebalancing at least once a year,” says Mastracci. Usually when you are either putting money in or taking money out. That minimizes the taxes that are triggered.”
Even seasoned investors can easily get off track, he warns, pointing to a couple who came to him with sizable portfolios that were out of sync with the pair’s financial goals. Jim and Mary Ackerley* had always earned good salaries and been diligent savers, maximizing RRSP contributions and savings in a non-registered portfolio as well. The couple – who are in their mid-50s – had a combination of RRSP and non-registered portfolios worth $465,000 in his case and $520,000 in hers. It all looked pretty good at first glance. But when Mastracci took a closer look, he found several problems in their asset allocations. The first issue was an overexposure to equities. He determined that an equity weighting of 85% made them far too vulnerable to market fluctuations, especially given they were only five to 10 years from retirement.
Another significant error was too many funds but not enough diversification. “The entire portfolio was much the same, even though there were 21 mutual funds in it,” says Mastracci. “People think they have diversity because they have so many funds. But when you take the names off the funds and look at the funds’ investment holdings, in many cases you’re seeing 50%-80% similarity among them.”
So Mastracci did a detailed investor profile and reviewed their investment goals. He found the right asset mix was more like 60% equities and 40% fixed-income. “We made the RRSP more conservative and put more of the risk in the personal portfolio. That one has about 70% equities. [Because] they didn’t have pension plans, we wanted the RRSP to be less risky,” he says.
In the end, the portfolios went from a total of 21 funds to eight.
Investors have the option of having their advisors customize their asset allocations for them, or they can purchase a portfolio of existing funds. Just be careful, warns Mastracci, that you are not paying extra fees for those portfolios.
Most banks and mutual fund companies sell portfolios of funds or funds of funds, with the strategic asset allocation built into the portfolios and the rebalancing done automatically. For example, at TD Canada Trust, there are five portfolios designed for five investor risk profiles.
“We see the asset-allocation decision for an investor as [being] really paramount,” says Karl Schulz, vice president and managing director. “Certainly for the average investor, the discipline part of investing is hard to maintain,” he says. I do believe these types of packaged solutions have been very important. They do a lot of the work for you. A lot of it has to do with the market experience people had with the market boom and then correction,” he adds.
In his practice, Mastracci recommends no more than three or four funds for an investor starting out, so he or she can keep track of them. As assets accumulate, more diversification can be added. He says the first level of diversification should be by security type – a mix of equity and bond instruments, for example.
After that comes geography. By having assets inside and outside of Canada, investors benefit when one part of the world is doing well while another lags. Canadian, U.S. and European markets tend to have a high correlation with each other, but emerging markets are often out of step with developed markets.
In the management of funds, Gordon Garmaise diversifies across many asset classes, including small- and large-cap funds, value and growth stocks industries, risk levels, bond issuers and markets. And don’t forget about management style, he says. By investing in a combination of funds, some managed with a growth style, others with a value style, investors should see less volatility. Growth funds – which focus on strong growth in earnings – tend to perform better in bull markets but are more volatile; value funds, which look for stocks that trade at less than their underlying assets, stand their ground better in bear markets and have less volatility over the long term. But, Garmaise warns, determining a fund’s management style is sometimes difficult.
“The name of a fund is not necessarily an indication of a fund’s style,” he says. It takes a certain technical expertise to determine the style exposure of a fund.”
If you are getting into that level of diversification, that’s where professional advice can be helpful.
Garmaise says taking advantage of the power of negative correlation – investments that behave differently from each other at a given time – is a fundamental part of asset allocation. “Correlation is not that important when looking within an asset class. Canadian equity funds tend to have a high correlation with one another. Where correlation gets interesting is across asset classes,” he says.
For example, most investors will benefit from having both Canadian and international equity funds in their portfolio, he says. Canadian stocks and bonds have a still lower relationship with each other. And one of the lowest correlations is Canadian, U.S. and international equity funds with foreign bond funds.
Most important, once you have the right allocation, don’t get caught up in short-term fluctuations, say the experts.
“People like short-term feedback, and that has led some of us to monitor investments daily,” explains Ena Garmaise. Monitoring the daily ups and downs of any mutual fund portfolio makes it difficult for some people to stay the course. “When you evaluate it too frequently, you’re more likely to abandon a higher equity strategy. In other words, you’re not going to meet your goals,” she says.
While so much has changed in the world in the 50 years since Markowitz first published his portfolio theory, it is amazing to see that the core ideas of that theory still apply, says Gordon Garmaise. “I am a great believer that the past eight years have shown how clever Harry Markowitz was,” he says. “His idea has certainly proved its worth during the remarkable bull and bear markets we saw around the turn of the millennium.”
* Names changed.
Mastracci’s Asset Allocation Bloopers
- Lack of investment strategy. Having no blueprint can result in either high allocations to equities, which brings too much risk, or money idling in money market funds, which provide meagre returns.
- Not knowing your tolerance for risk. This typically reduces the quality of the picks.
- Lack of diversification. Even if you hold many mutual funds, the holdings can be very similar.
- Chasing yesterday’s performance. Buying last year’s hot performer wreaks havoc on your asset mix.
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