The final core asset class is equity. Cash and fixed income the other two core classes.
Technically, equity includes preferred shares. However, I normally include preferred shares in fixed income. In fact, many offered preferred features look very much like fixed income. And investors normally buy preferred shares for the income stream, not capital gains. As such, we will equate common shares with equity for now.
We can utilize percentage target asset allocations for common share equities.
Once again, the “right” allocation is determined by your own comprehensive investor profile. It will be unique to your needs, desires, and circumstances. Keys include your current financial situation, phase in the life cycle, and risk tolerance.
Here are a few thoughts from my side.
Common Shares
Common shares traditionally have the highest risk and expected return of the three core asset classes. Though, as we saw earlier, within any asset class itself, there may be a wide variance in expected risk and return scenarios.
Some common shares distribute dividends and may be purchased for an income stream. But most common shares are acquired for capital appreciation potential, rather than pure income generation.
Common shares are more suitable for investors who can handle higher volatility in their investments. This may include investors with long time horizons, those that do not require immediate liquidity, and those with more aggressive levels of risk tolerance.
Equity for Accumulators
Common shares are well suited for Accumulators.
Accumulators generally have the longest time horizon of any investor group, so they can more readily ride out the fluctuations of higher risk assets. At times, liquidity may be an issue for Accumulators owning common shares. But if they properly plan their cash reserves, that should not be a major concern.
With the highest expected returns and the fact that Accumulators can handle the higher risk, it should make sense that Accumulators invest 100% of their wealth (less any cash reserves) in common shares.
Too Much of a Good Thing
It may seem to make sense, but probably not the best strategy in actuality.
That is because of the risk reduction benefits in diversifying one’s investment portfolio across multiple asset classes.
The Magic Number
As an Accumulator, wealth allocated to cash equivalents may be proportionately high. Say 20%. If you allocate another 5-25% in fixed income, that leaves between 55-75% available for common shares.
Probably a good range for most Accumulators.
Of course, your risk tolerance may lead you to increase or decrease the amount you allocate to common shares.
Further, as you consider investing in alternative asset classes, that will also impact your allocation to common shares.
Equity for Consolidators
Common shares are also very good investments for Consolidators.
The same rationale applies to Consolidators as to Accumulators. Those with relatively long time horizons should focus on higher risk investments.
The Magic Number
Consolidators have already accrued some wealth. Cash reserves, as a percentage of accumulated capital, will be less than in the Accumulation phase. Say 5% in cash equivalents. I suggested 10-30% in fixed income for the generic Consolidator in a previous post. That would leave 65-85% for common shares.
That seems to me a decent range for a Consolidator with a moderate risk tolerance. If your personal risk level differs, you should adjust the percentage accordingly.
While this is a good starting point, I would offer a couple of potential amendments.
First, as you age within the Consolidation stage of life, you may want to slowly lower your risk tolerance over time. This reflects your ever reducing time horizon and the desire to begin generating a fixed income stream for retirement. One that also improves portfolio stability and liquidity.
Second, as you increase your wealth and investment expertise, you probably will want to consider alternative asset classes. Real estate is common for investors. There are many other classes as well. The extent that you allocate a portion of your capital to alternative assets will also impact the percentage allocated to common shares.
Common Shares May Provide Alternative Asset Class Exposure
I will note though, that most investors never need to consider alternate asset classes. A well-diversified portfolio of common shares tends to cover many other classes.
For example, you own a passive index fund covering Canadian common shares. How about iShares Core S&P/TSX Capped Composite Index ETF (XIC)? Yes, this is part of your equity asset allocation. But the fund itself provides nice exposure to alternative asset classes. A top 10 fund holding, Brookfield Asset Management’s business involves real estate, renewable power, and private equity. Barrick Gold is another significant member of the index. As is Nutrien. There are multiple Real Estate Investment Trusts (REITs) within the index, providing real estate exposure. And so on.
Do not believe you require adding specialized alternative asset class products to get exposure in those sectors.
Equity for Spenders
During retirement, there will probably be little income from employment or business. Spenders will normally need to live off their savings and pensions. As such, Spenders desire liquid, low risk investments, that provide a constant stream of cash flow. This suggests a shift from higher risk equities into lower risk fixed income assets.
And many Spenders do lower their component of common shares to a minimal amount.
But I do not think this is prudent for most investors.
An Ever Lengthening Time Horizon
Despite the natural inclination to lower your risk tolerance and seek safe investments, you should not completely succumb to this approach. The main reason is today’s life expectancy.
Traditionally, people worked until 65 and then retired and lived off pensions. That was not a problem previously. According to U.S. National Center for Health Statistics, National Vital Statistics Reports, in 1950 the U.S. life expectancy was only 68.1 years of age. Three years from retirement to (average) death did not require significant savings.
But by 1970, life expectancy had risen to 70.8 years. By 1990, it was 75.4. For 2010, 78.3 years. And for 2020, life expectancy is projected at 79.5 (81.9 if you are female).
If you retire with same assumptions that they used in 1970, you may fall 9 years short in your ability to live.
That means you may need to work longer than 65, start saving much earlier to accumulate more wealth, and/or increase the level of risk in your retirement portfolio to compensate for a longer life.
The Magic Number
For the generic Spender, by retirement you may have about 10% allocated to cash equivalents and another 30-40% in fixed income. That leaves about 50-60% for common shares and alternative asset classes.
As the generic spender moves through the Spending phase, the percentage allocated to higher risk equities should decrease over time. A gradual reduction to 20-30% in common shares may be appropriate for the average Spender.
How fast you adjust your allocation depends on your financial situation, risk tolerance, and personal circumstances.
Perhaps you retire at 65 with $100,000 in capital and plan to live another 20 years. At a 5% return, an annuity would pay you $657.22 monthly Not great.
But if you had accumulated $500,000 in capital, that same annuity would provide $3286.09 monthly. Much better.
And if you had saved $2,000,000, your annuity would pay $13,144.35.
If you have accumulated closer to $100,000 than $2,000,0000, you may need to take on additional risk comfortably live through retirement.
If you could earn 10%, rather than 5%, your $100,000 annuity would pay $957.05 monthly. And at a 15% return, your annuity would pay $1300.53 monthly. Both are an improvement over $657.22 at 5%.
Personal circumstances also play a role in your allocation decision.
If your family all lives to 100, you may want to plan on a longer life than the average.
If you live in a location with a high cost of living, you may need to generate greater returns to keep up with inflation and higher expenses. For example, retiring in the Cayman Islands is a more expensive prospect than living out your days in Saskatchewan, Canada.
Conclusion
Those are my thoughts on target asset allocation considerations for common shares, fixed income, and cash equivalents.
Some general asset allocation principles that make sense for most investors.
Invest in higher risk and return assets when you have long time horizons. Shift into more liquid investments that provide a fixed income stream as you age and require safety. Diversify across asset classes to lower portfolio risk.
However, your personal circumstances will play a huge role in the right allocation for you.
Your current financial situation, investment objectives and constraints.
Your investment time horizon, phase of life cycle, and risk tolerance.
These variables are unique for each investor. They do not easily fit into a generic asset allocation calculator. They must be considered both separately as well as in their entirety.
That is why attention to your comprehensive investor profile is crucial.
