By JoAnne Sommers
Vision Magazine
May-June 2006 Issue
Would you build a house without a blueprint? Adrian Mastracci hopes not. But as an independent investment counsel, Mastracci, president of KCM Wealth Management Inc. in Vancouver, finds that many people make this mistake when it comes to constructing their financial houses.
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “Many investors are surprised to learn that their portfolios are heavily skewed in ways that don’t match their risk tolerance.”
Asset allocation is like the blueprint for building a house and, unfortunately, it’s a subject that is not well understood, says Mastracci. “I rarely meet clients who have an asset allocation plan. And most investors are confused about what the term even means.”
Simply put, an asset allocation plan is a game plan for investing: creating this plan is the process of determining optimal allocations for the broad categories of assets, such as stocks (equities), bonds, cash vehicles, real estate and so on.
The goal of such a plan is diversification, the rationale being that portfolios with a variety of holdings tend to be less volatile than those concentrated in a single type of investment. “Each asset class will generally have different levels of return and risk,” Mastracci explains. “They also behave differently. While one asset is increasing in value, another may be decreasing or not increasing as much. Then their roles might reverse.”
In Mastracci’s experience, asset allocation decisions have a greater impact on the performance of a client’s investment portfolio than any other factor. This opinion is backed by several studies, including those by Harry M. Markowitz, Merton H. Miller and William F. Sharpe, winners of the 1990 Nobel Prize in Economics. In addition, a 1986 study published by Gary Brinson, Randolph Hood and Gilbert Beebower, looked at 91 very large pension plans in the U.S. and concluded that asset allocation explains on average 94 per cent of the variation over time in total plan returns. In sharp contrast, stock selection and market timing explained only small contributions.
Skewed Portfolios
Many investors are surprised to learn that their portfolios are heavily skewed in ways that don’t match their risk tolerance. “One woman came to see me and was surprised to learn that she had 21 different funds but that 84 per cent of her investments were in equities,” says Mastracci. “Her risk tolerance showed her to be more of a 60 per cent equities person. So I will be making changes to bring her asset allocations into line with her needs.”
A related problem is that people mistake having a variety of funds with having a diversified portfolio. “They might have 25 funds but the top 10 or 20 are often invested in the same Canadian companies. An overlap of up to 70 per cent is not unusual in my experience -- and it’s not advisable.”
Achieving Financial Independence
Most people would like to be in the position of working because they want to, not because they have to. Moving toward this kind of financial independence takes a sound asset allocation plan that begins with a financial independence analysis.
“The financial independence analysis for each client captures the personal financial wish list and estimates the value of investments required to provide for the stated goals,” explains Mastracci. “More importantly, I also calculate what rate of return is necessary to achieve this capital value.”
As an example, Mastracci points to a male, aged 47, who wants financial independence at age 60, with $75,000 of before-tax annual income in today’s terms for the rest of his life. “He needs an investment portfolio approximating $2 million by age 60, assuming inflation at 3 per cent annually. A female of the same age needs about $2.2 million because she’s likely to live longer.”
According to Mastracci, the most critical part of this exercise is to determine the investment rate of return necessary for the client to achieve his or her unique financial independence target. Once this is known, the client’s investments are geared to achieving the necessary rate of return, while incurring no more risk than necessary.
The analysis takes into account:
- Long-term goals, with emphasis on financial independence and retirement aspirations
- Investment objectives for the non-registered (personal, business, family trust, holding company) and registered (RRSP, RRIF, DPSP, IPP, RESP) portfolios
- Investment time horizon and risk tolerance
- Income and capital draws required from the portfolio
- Income tax and estate considerations
- Asset allocations related to investment personality (conservative, income, balanced, growth, or aggressive) and to the client’s personal rate of return to achieve financial independence
- Selection of the appropriate portfolio securities
- Disposition, acquisition and holding costs of the securities
- Transition steps from the current to the suggested portfolio
A tailor-made asset allocation plan is the best recipe for successful personal wealth accumulation. As Mastracci sums it up: “Managing money is a marathon, not a 100-yard dash. The proven and consistent approach to creating, growing or preserving wealth is to take the long-term perspective.”
Typical Investment Profiles
This table provides an overview of investment profiles, based on the investor’s risk tolerance and age. Typically, investors become more risk-averse as they age and the time period during which they can continue to build wealth shortens.
| Profile |
Asset Allocation Targets |
Target Age Group |
| Equity |
Fixed Income |
| Conservative |
15% |
85% |
75 to 90 |
| Income |
35% |
65% |
65 to 90 |
| Balanced |
50% |
50% |
50 to 90 |
| Growth |
60% |
40% |
40 to 70 |
| Aggressive |
80% |
20% |
30 to 45 |
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Source: KCM Wealth Management Inc.
Conservative: These are investors who have little tolerance for unpredictable returns and invest primarily in guaranteed interest-yielding vehicles, such as government bonds, GICs, and Canada Savings Bonds.
Income: This profile group has low tolerance for variation in returns. They usually want stability with fairly predictable growth, allowing for some fluctuation. Thirty-five per cent in equities gives them some growth, while the preponderance of investments in fixed income assets provides stability.
Balanced: These investors are looking for a trade-off between growth and the security of their capital. A 50/50 split suits them well.
Growth: This profile group is made up of patient investors who can stand a little more risk. They are primarily interested in growth but also want some capital preservation. Keeping 40 per cent in fixed assets gives them some stability.
Aggressive: These investors are willing to tolerate much great fluctuation in prices, and they look for superior long-term results. They can accept greater variations in return in the short term, knowing that over time their investments will probably perform well or very well. Fixed income or a cash component isn’t that important to them. Any funds in the fixed category are usually parked there for a limited time until they can find a growth investment.
When to Rebalance
In Mastracci’s experience once he and the client come up with a suitable asset allocation strategy, it usually continues to match the client’s needs and temperament for many years. But the portfolio may need to be rebalanced from time to time, depending on its results. “If you’re a balanced investor and one of the categories moves up five or 10 per cent, it should be tweaked to get it back into alignment. If, however, you’re an aggressive investor, a fluctuation of 10 or even 20 per cent is not a big deal. If a client moves money in or out of the portfolio, that is usually a good time to look again at the allocation and make sure it’s still correct for that person. Otherwise, I review each portfolio quarterly. I’m not one to play the markets, chasing short-term results. Studies show that it doesn’t pay off in the long run, and, if it isn’t broke, why fix it?”
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