If Canadians knew that the stock market was certain to go up by 10% over the next few years, would they bother holding 3%-yielding Guaranteed Investment Certificates (GICs) or bonds in their portfolios? Probably not! And this is why asset allocation is important.
American billionaire, hedge fund manager, and investor extraordinaire Raymond Dalio — founder of Bridgewater Associates, one of the largest hedge funds in contemporary times — once said:
You should have a strategic asset allocation mix that assumes that you don’t know what the future is going to hold.
Wise advice. But what does this look like in practice? Let’s take a look.
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What Is Asset Allocation?
Think of your portfolio as the proverbial “basket,” and the various asset classes held in that portfolio represent “eggs.” Asset allocation is the conscious distribution of your invested capital (in your basket) among various types of assets (your eggs).
When it comes to strategically allocating assets across a portfolio, good investment practice dictates that you shouldn’t hold just a single type of asset in the portfolio. Instead, allocate your investment dollars to a range of assets. Essentially, the advice is that old adage: don’t put all your eggs in one basket. But why?
If a single class of assets doesn’t perform well over a period of time, you are likely to do better if you also hold other asset types in that portfolio. That way, if one asset (again, thinking of the above egg example) falls and breaks, others will remain intact to deliver you the portfolio returns that are looking for.
Notice how we stressed the word “likely”? Well, that’s intentional! Smart portfolios are constructed so as to not leave much to chance. And that’s where strategic asset allocation comes in. While good asset allocation helps you avoid putting all your eggs in a single basket, strategic asset allocation invests in asset classes based on your personal circumstances.
Deliberate asset allocation
A couple of decades or so ago, the asset allocation rule of thumb was quite straightforward. The formula? Subtract your age from 100 and then invest that much (as a percentage) of your nest egg in equities. The rest of your investments would be spread into bonds, GICs, and other fixed-income instruments. So, a 40-year-old would have 60% equities in their portfolio, while a 60-year-old would have 40% allocated to equities.
Well, guess what? That formula does not work anymore. Here’s why:
- Firstly, on average, Canadians are living much longer today than 20 or 30 years ago. So, for a 60-year old investor to allocate only 40% (100 minus 60) of his/her portfolio into equities makes no sense – especially if the remaining 60% is yielding returns that are barely above inflation.
- Secondly, if the above 60% of a non-equity portfolio is barely keeping up with inflation, how will the person live off their portfolio for the next 35 or 40 years? That’s just not possible!
Today’s wealth managers, therefore, don’t embrace cookie-cutter asset allocation formulas. They might start off with an asset allocation loosely based on the ‘100-minus-age’ formula — perhaps substituting 100 with 110 or even 120. Then, they construct deliberate asset allocation plans uniquely tailored based on the individual investor’s personal circumstances.
And what might those circumstances be?
How to allocate assets in a portfolio
Just as no two individuals are alike, no two portfolios should be constructed identically. That’s why asset managers allocate assets to a portfolio based on each investor’s profile.
Your investor profile
What goes into an investor’s profile? Here’s the rundown:
- Your age: Generally speaking, younger investors can afford to allocate more capital to slightly riskier assets. Why? Because in the event of a market downturn, you’ll have many years ahead of you to let your portfolio recover those losses.
- The size of your portfolio: The smaller your portfolio, the less diverse your assets might be. For instance, if all you have is $5,000, would you be comfortable risking it all on volatile stocks? Probably not. Your best bet would be to invest it all in a super-safe money market fund.
- Your investment time horizon: The closer you are to drawing down your portfolio, the less risk you want to take. If you have a one to two-year investment time horizon, then your portfolio should be heavily tilted to less risky assets – e.g. money market funds, GICs, or annuities.
- Your risk tolerance: The greater your risk appetite, the more capital you can allocate to riskier assets like equities.
- The expected rewards from allocated capital: Smart asset allocation is definitely about protecting your capital. But it is also about earning a decent return. So, if a 5-year GIC promises you 2.75%, and a slightly riskier asset (A+ credit-rated Canadian Corporate Bonds) is yielding 3.4% then, because of the risk-reward proposition, it makes sense to allocate some capital to the bonds.
What does a well-allocated portfolio look like?
So, when you put all of these pieces together, you could end up with a well-diversified portfolio, with assets allocated between:
- Stocks, bonds, and alternative assets
- A mix of equities across industries and sectors of the economy
- Stocks of small, mid, and large-cap companies
- Equities across a broad segment of the globe, from Canadian, U.S., Asian, European and Emerging economies
Spreading out your portfolio to include all of these different asset classes, based on the profile characteristics discussed earlier, is what strategic asset allocation is all about. But like all other advice in life, there are exceptions.
Additional considerations for asset allocation
If you stick with the asset allocation building blocks discussed earlier, you should have a pretty well-diversified portfolio that will help you grow and preserve your wealth. However, you might not need to worry about too broad an allocation if:
- A significant portion of your future needs will come from a “guaranteed” company Defined Benefits Pension plan; or
- If you expect to meet most of your retirement expenses from the Canada Pension Plan (CPP) or other government income programs; or
- You already have a significant piece of your portfolio allocated to long-term fixed-income investments that are guaranteed to provide you with income sufficient to cover all your needs.
Smart asset allocation
A well-allocated portfolio means that you don’t need to worry about the short-term ups and downs of the market. It also means that you won’t need to be overly concerned if some assets perform poorly for a short time. That’s because smart asset allocation is also about ensuring that your assets aren’t closely correlated. For instance, if you buy and own all of the household tech companies in your portfolio – Apple, Google, Facebook, Twitter, Shopify – you might feel your portfolio is well allocated, but it’s not! Buying a lot of socks doesn’t make for great asset allocation. As Tony Robbins, the prolific and exuberant performance coach once said:
The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation
Working with a wealth management company that truly understands your needs, and is committed to creating personalized portfolios just for you, is the best way to ensure you have a portfolio of well-allocated assets.
Learn more about alternative investments from our series of blog articles: