|
By David Dias
Financial Post Business
Family Finance Issue
February 2007
Building a balanced, sustainable portfolio isn’t hard. You just have to know who you are and what you want.
Thanks to a revolution in retail investing, millions of us have taken control of our portfolios. The markets have become a great democracy, and it’s never been easier to participate. You don’t even have to leave home to do it. Just log in to your favourite discount broker’s website, and you’re clicks away from tweaking your portfolio with the purchase of a bond fund or preferred share, in search of that elusive balance between risk and reward.
Adrian Mastracci, fee-only portfolio manager at
KCM Wealth Management in Vancouver, says, "Building a portfolio is really only the first step in managing your nest egg. Because your investments are in constant flux, they’ll drift away from the targets you’ve set."
The trouble, of course, is that most of us haven’t the faintest clue as to what actually constitutes a balanced investment portfolio. Take, for instance, Harry and Linda Quon (not their real names). In the heated bull markets of recent years, losing money has been virtually impossible, but the Quons have managed to find a way. The hapless couple, 60 and 58 years old respectively, live in Vancouver, where Harry works as a professor, while Linda receives a government pension. They’ve accumulated a solid foundation of assets, including a fully paid-off house and two pensions. They’ve also got $440,000 in personal savings and investments — but they’ve handled that money poorly.
For starters, the Quons don’t have a financial planner and they’ve relied instead on friends for stock tips. That has led them to money-losing investments in banks, precious metals stocks and income trusts, which currently account for about 25% of their nest egg ($110,000). Another 25% is in equity funds, which have brought a small return, but not enough to make up for the lousy stock picks. The rest of their money — a whopping $220,000 — is sitting in a run-of-the-mill savings account. Understandably, their frustration over their portfolio has been mounting. They think their problem is that they’re not taking enough risk. “I’m not blaming Harry,” says Linda, “but I think sometimes he gets cold feet.” Harry acknowledges this, but says he has no idea how to start making things better.
If the Quons are concerned about risk, however, they’re missing the point. The big issue with their portfolio — and this applies to every investor trying to figure out what to do with his or her money — can be summed up in one word: composition. They simply haven’t considered how to structure the mix of their investments to meet their goals and expectations. But there’s good news: Given a few days of consideration and research, almost anyone can build the foundations of a balanced portfolio. All the Quons — or you — have to do is follow the basic steps our experts lay out in the pages ahead.
SET GOALS Every investment portfolio is designed to grow, but the way it grows can differ dramatically depending on your goals. Do you want your savings fund to simply stave off inflation? Do you want it to produce a steady stream of income? Or do you want it to grow for the long term and, if so, how quickly? Only once you’ve decided on your goals can you settle on a mix of assets likely to achieve those goals. This is where Harry and Linda have to begin. “They need to ask themselves what they want their money to do for them,” says Andrew Rice, a planner. It’s where you should start, too.
KNOW YOUR RISK TOLERANCE Your personality has a lot to do with your risk tolerance, but so does your situation in life. According to Rice, the closer you are to spending your money, the less risk you’re likely willing to take. If you know you’ll need the money in five years or so, you should invest it in a safer mix of mostly fixed-income products, such as bonds, income trusts and dividend-yielding stocks. If, on the other hand, you’re saving for, say, a retirement that’s 30 years away, you probably have the luxury of riding out downturns in the market and can invest in a riskier mix of mostly equity vehicles, such as index and equity funds or even individual stocks. In short, “you’re matching the time horizon of the portfolio to the goals,” says Rice.
Given these considerations, most investors can be categorized under one of six basic archetypes along the risk-tolerance spectrum, says Adrian Mastracci, a portfolio manager at Vancouver-based KCM Wealth Management:
- At the high-risk end of the scale is the speculative investor, who keeps 80% to 100% of his or her assets in equities, with the balance in fixed-income. These investors are typically 25 to 40 years old and accept higher risks knowing that they’ll have time to recover from downturns in the market.
- Aggressive investors take somewhat less risk than speculative investors, but still devote about 80% of their portfolios to equities. Again, this approach is better suited to younger investors who have time to recover from losses.
- Growth investors put 60% of their portfolios in equities, with the balance in fixed-income assets. This style is suited to any investor up to the age of 70 who’s willing to take on some risk.
- Balanced investors split their assets equally between equities and fixed-income vehicles. Like growth investors, they follow a style that’s well-suited to a large number of people, although balanced investors tend to be over the age of 50.
- Income investors are usually over the age of 60 and in retirement. Their portfolios are safer still, with about 65% of assets in fixed-income investments and 35% in equities.
- Finally, there are the conservative investors, usually 65 to 90 years old, who keep about 85% of their investments in fixed-income.
Harry and Linda will have to decide on their own where they fit into this spectrum, but as long as they can tolerate some risk of loss, they’d probably do nicely in the “balanced” category, with 50% exposure to equities. According to historical data researched by money-management firm Philips, Hager & North, this type of portfolio would have resulted in only six negative years since 1970, with the worst fall, at 15%, occurring in 1974. Better yet, it would have averaged an 11% annual return over the same period. Someone who’d taken more risk over this period, say 70% equity exposure, would have suffered a 19% loss in 1974, while their average annual return would have been 11.5%.
MANAGE FIXED-INCOME ASSETS Investors need only call a discount broker to purchase a wide range of fixed-income securities — everything from higher-risk corporate junk bonds to guaranteed Canada Savings Bonds. But choosing a product doesn’t have to be a major chore. In fact, Mastracci recommends that average investors stick simply with middle-of-the-road treasury bills, banker’s acceptances and government strip bonds, which offer slightly higher returns than your humdrum GIC.
Regardless of the product itself, Mastracci advises a “laddered” approach to fixed-income investments. This entails divvying up your assets into five or 10 investments, maturing at regular intervals over five years. In Harry’s and Linda’s case, for instance, Mastracci suggests they start by moving about $180,000 of their cash into 10 fixed-income investments of $18,000. “What you probably want is one or two maturities every year,” says Mastracci. This would allow them to make longer-term deposits, thus earning better returns compared to a savings account, while ensuring that they’re never far from an infusion of cash.
MANAGE EQUITY ASSETS Managing equity doesn’t have to be difficult. In fact, it can be as simple as buying an equity fund with exposure to Canadian, U.S. and global stocks. But Mastracci says it’s not especially hard to build your own fund, and thereby avoid fees charged by fund managers. All you need is to purchase a good mix of equities that track major stock-market indexes, such as exchange-traded funds and index funds.
Investors with higher risk tolerance will want to overload on specific indexes or sectors that they believe will outperform broader markets. For most people, however, Mastracci recommends buying five to 10 index funds and ETFs, and distributing investment cash in a mix that’s three parts Canadian (such as the S&P/TSX 60), two parts American (such as the S&P 500) and one part international (such as an MSCI global fund).
As for the Quons, they’ve concentrated too much on individual stocks. As a result, they’ve skewed their portfolio toward the “speculative” side of the risk spectrum. Holding individual stocks or industry sectors is fine if you know what you’re doing, Mastracci says, but for most of us, managed funds make more sense. “The key is that no one stock going south will cause big problems.”
REBALANCE ANNUALLY Building a portfolio is really only the first step in managing your nest egg, says Mastracci. Because your investments are in constant flux, they’ll drift away from the targets you’ve set. If the value of your equities rises, for instance, you may find that you’re suddenly underweight in fixed-income. For this reason, he recommends reviewing your portfolio annually to make sure it reflects your investment style and mix.
According to Rice and Mastracci, anyone who follows the advice they’ve laid out here should be on their way to building a decent portfolio. If the work sounds daunting, Rice humbly suggests hiring a financial planner to take you through the process and help you stay the course. Alternatively, if you want do everything yourself, you might consider putting your savings into a balanced mutual fund, which is already managed to have international exposure and a set proportion of fixed-income.
But above all, Rice and Mastracci both reiterate that investors must first consider what goals they want to achieve with their portfolio. Harry and Linda Quon haven’t done that yet, and they won’t be on a path to solving their problems until they do. “It’s like trying to build house without a blueprint,” Mastracci says. Their mistakes should be a lesson for us all.
|
