Asset Allocation – Why You Should Care

by Invisor Last updated on January 14, 2015 Tags: Retire Early, Save Well

The beginning of a new year is when many investors start to assess the longer term performance of their investments and start to think about investing any year-end bonus payments received to top-up their RRSP (Registered Retired Savings Plan) and TFSA (Tax-Free Savings Account) limits.

But, do you know if your investment portfolio is sufficiently diversified and aligned with your goals?

In speaking to prospective clients, the most common issue we note is that their existing portfolios are neither diversified adequately, nor tailored to meet their goals and risk tolerances.

Let’s use a real-life example to illustrate the significance of this issue. Here is he profile and the existing portfolio of a client we recently worked with:

Age: 40 | Goal: Retirement | Time Horizon: 15 to 20 years | Risk Tolerance: Medium to High

Current Asset Allocation:
Current Asset Allocation
The bond exposure in the portfolio (67%) was established through a Target Date 2020 Fund – a fund of fund product typically meant for investors who are planning to retire in the year 2020.

Upon inquiring the basis for her current mutual fund holdings, our client admitted that she hadn’t given a lot of thought to it and completely relied on her advisor. Furthermore, she was incurring a total cost of 2.63% on a primarily bond portfolio, which had an average 5-year return of a little over 6% (thanks to the strong performance of the small cap equities and declining interest rates during this period!).

But does this represent optimal asset allocation considering her objectives, risk tolerance and time horizon to retirement? Why was she invested in a Target Date 2020 Fund with a significant exposure to fixed income securities when she was seeking growth in her portfolio with no plans to retire in the next 20 years? What was the basis for 20%-plus allocation to Canadian Small-Cap stocks when there was no allocation to other large and mid-cap stocks?

So what is Asset Allocation?
Asset Allocation is an investment strategy that seeks to balance risk and reward by apportioning the portfolio’s assets over various asset classes, in accordance with an investor’s goals, risk tolerance and investment horizon.

An asset class is a group of securities that have similar financial characteristics and generally behave similarly in the marketplace. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments). Each of these asset classes is expected to reflect different risk and return characteristics, and generally perform differently in a given market environment. The major asset classes are then typically grouped into various sub-asset classes based on regions (such as US, Canadian, developed market, emerging market equities) or specific types (such as commodities, real estate) or by credit quality (such as investment grade, high-yield). These asset classes are then combined in different proportions to form the overall asset allocation aligned with an investor’s goals and risk tolerance.

Why is Asset Allocation important?
Backed by research, there is a general consensus amongst the investment professionals that asset allocation is the most important decision that contributes to the overall performance of a portfolio over time. In other words, selection of individual securities (stocks, bonds, funds, etc.) is secondary to an investor’s asset allocation decision. A well-diversified portfolio across various asset classes reduces risk for the level of return an investor seeks, especially during times of market stress.

How to approach asset allocation?
Start with your investment goals, the time horizon for each of your goals, and your risk tolerance. Once you have considered each of these elements, determine the overall exposure you would want to each of the major asset classes, equities, bonds and short-term instruments. For example if you have a longer time horizon (say 10 years or more) and a medium to high risk tolerance, you may want a greater proportion of exposure to equities than bonds.

Next, you would determine the sub-categories within each of the major asset classes that you would want exposure to. For example, think about how much exposure within the equity component you want, to US Equities, Canadian Equities, Global Equities, etc. You may also consider exposure to other asset classes like Real Estate, Commodities etc., which would all depend on how much risk you are willing to bear and how the various classes correlate with each other. The goal should be to reduce the overall risk of the portfolio by adding certain asset classes that correlate less with other asset classes included in the portfolio.

Many professional investment managers take into account their market expectations in selecting the weights of the various asset classes. They evaluate how the various asset classes have performed in the past, their current valuations and how they are likely to perform going forward considering economic conditions. This element of portfolio construction would certainly need skill and it would be appropriate for most investors to work with an investment advisor.

The last step would be to select the securities and funds that fit well within the asset allocation plan determined. As we know, for most individual investors, using low-cost mutual funds and exchange traded funds is a very cost effective way to build a portfolio that is well diversified across various asset classes.

You will then need to monitor your portfolio over time and rebalance the holdings when their weights deviate from the tolerance range established. Trading cost causes a drag on the portfolio over time and therefore you should seek to minimize trading as much as possible.

In building your investment plan, always adopt a top-down approach – start with your goals and risk tolerance, and then consider the asset classes you want exposure to, for each of your goals.

If you are working with an advisor, ask questions on the basis of the asset allocation plan recommended and how investment products have been selected to construct the intended asset class exposure.

Remember, there is research indicating that in many cases over 90% of a portfolio’s return is determined by asset allocation decisions. Individual security selection is important, but not as significant a determinant of portfolio returns.

For our prospective client, we constructed a portfolio of low-cost mutual funds and exchange traded funds with diversified exposure to key asset classes that aligned with her goals and risk tolerances, including Canadian, US & other international equities, real estate, and corporate bonds. As well, her overall cost of investing dropped to about 1.10% from the current 2.63% that she was incurring; meaning more of her savings was working towards funding her retirement rather than paying commissions to sales intermediaries!

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