by WWM | Mar 27, 2019 | Fixed Income, Target Asset Allocation
In Asset Allocation: Fixed Income (Part 1), we quickly reviewed fixed income as an asset class. We then considered fixed income allocations for Accumulators. Finally, we saw how fixed income can provide excellent diversification benefits within a portfolio. Asset correlations between, and within, asset classes, being so important.
In Part 2, how to determine a fixed income allocation for the Consolidator and Spender life cycle phases.
Fixed Income for Consolidators
Consolidators are older, but still have lengthy time horizons in which to invest. Consolidators should have some wealth accumulated and their investments in cash equivalents will reflect this. Perhaps 5-10% of total assets will be in cash.
Not the Best, But Not Bad
Because of the relatively long time frame, fixed income should not dominate the portfolio. Rather, the focus should be on investments with greater capital growth potential.
Same as with Accumulators.
Becomes Better With Age
As the time to retirement shrinks, Consolidators should increase their allocation to fixed income. This will solidify previous accumulated portfolio gains, reduce overall portfolio risk, and begin to generate stable income flows for retirement.
But not too much, as we shall see below.
The Magic Number
For the generic Consolidator, 10%-30% allocated to fixed income may be appropriate. The increase from the Accumulation phase simply reflects a reduction in necessary cash equivalents to about 5%. The suggested allocation also takes into account that Consolidators often invest in alternative asset classes.
One’s risk tolerance will determine the appropriate allocation. If you are extremely risk averse a higher percentage allocated to fixed income may be appropriate. It is your portfolio. You need to be comfortable with your investments. Because it is also your (potential) ulcer.
Finally, the extent that you invest in non-traditional investments (e.g., derivatives, commodities, venture capital, etc.) will impact your ultimate allocations.
The wider you spread your investments, the less that is usually allocated to any one class. How you diversify your portfolio will depend on your investment knowledge, comfort level, risk preferences, asset correlations, and the like.
Fixed Income for Spenders
Spenders are usually individuals at retirement age. Employment or business income has ceased and Spenders need to live on their pensions and savings.
Spenders are generally risk averse. This reflects the reduced time horizon for surviving asset volatility.
Because of this, Spenders traditionally invest primarily in fixed income and cash equivalents.
Now We Are Talking
These asset classes provide the stability, consistency, and liquidity, Spenders want.
Many Spenders invest 80-90% of their wealth in cash and fixed income.
However, the trade-off for low risk investments is a low return. And that is a problem.
Too Much of a Good Thing
Today, many people retire between 55 and 65. Yet many retirees now live until at least their 80s. That means Spenders may need to live off their savings for 25 years. Often, much more.
That is a long time to survive on investments with low returns.
With longer lives (and investment time frames), Spenders should strongly consider maintaining a portion of assets in investments with potentially higher returns.
I would suggest that investors do not allocate 80% to cash and fixed income. Keep a portion in equities and other asset classes with better expected returns.
The Magic Number
At retirement time for the generic Spender, perhaps 30%-40% in fixed income is suitable. That assumes about 10% in cash equivalents at that date.
As one continues to age, additional assets should shift into cash and fixed income instruments.
Personal factors need to be taken into account. Theses include: health situation; family history of death age; wealth accumulated; cost of living; prevailing interest rates.
If you expect to live until 110, you need to plan for that in your investing and drawdowns.
If your accumulated wealth is high, you can take a safe investment path. But if you have not saved enough for retirement, you may want or need to try and generate greater returns with riskier assets.
If interest rates are low, your level of income will also be low. If it is insufficient to cover your mandatory costs, you may also need to try to boost returns with higher risk investments.
However, higher risk means increased volatility and possibility of loss.
Where you are at retirement will play a significant role in your actual asset allocation.
Your Personal Risk Tolerance Impacts Allocations
And, as is always the case, your personal risk tolerance plays a part in the allocation. When you retire, as well as how you reallocate during your retirement years.
Most Spenders should have relatively low risk tolerance. This reflects the lack of other income on which to live and the reduced investment time frame.
But some Spenders may be extreme and want almost everything invested in safe investments. They will sacrifice some income in order to sleep well at night. Other investors with higher risk tolerances may ignore the shorter time horizon and still want a significant portion of their assets in less stable investments.
Whether you are an Accumulator, Consolidator, or Spender, one size never fits all in a specific phase of life. There may be general rules of thumb. But each allocation should be tailored expressly for your own unique circumstances.
Next up, equity allocation considerations.
by WWM | Mar 20, 2019 | Fixed Income, Target Asset Allocation
Fixed income is the second core asset class.
Here we can start to look at percentage allocations when investing.
Again, the investor profile will determine the appropriate amount to invest in fixed income.
Within the profile, the phase of one’s life cycle and the investor’s risk tolerance are keys.
Fixed Income Recap
Fixed income normally includes bonds, debentures, notes and preferred shares.
Fixed income is generally higher risk and higher return than cash equivalents. But it has a lower level of risk and expected return than common shares. Fixed income may be sought by relatively risk averse investors.
Of course, within the asset class, the expected risk-return profile may fluctuate substantially.
People who desire a constant stream of income liked fixed income. Though one can also buy zero coupon bonds.
What about the suitability of fixed income for those in the different phases of the life cycle?
Fixed Income for Accumulators
Not Really Suitable Investments
The logic goes that Accumulators tend to be young, with extremely long investment horizons. As a result, they can better absorb the fluctuations of higher risk and higher return investments than those in other phases of life. Because of this, Accumulators tend not to emphasize lower risk fixed income in their portfolios.
I agree with this logic.
Unless extremely risk averse, Accumulators should not invest heavily in fixed income assets.
But Do Not Exclude Completely
But that does not mean they should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.
For example, consider a few current inter-asset correlations. I will use data from Portfolio Visualizer as at March 15, 2019.
The current 10 year correlation between 20 Year U.S. Treasury Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.47; U.S. Mid Cap Stocks −0.46; U.S. Small Cap Stocks −0.45; International (excluding U.S) Stocks -0.43; Emerging Market Stocks -0.38.
If you recall our discussion of correlations, combining two assets with negative correlations is very beneficial in reducing portfolio risk. And any correlation below 1.0 (perfect positive correlation) improves overall portfolio efficiency. But the lower, all the way to -1.0 (perfect negative correlation), the better for diversification of portfolio risk.
When we look at alternative asset classes, we shall see that fixed income can also enhance diversification. Consider the latest 10 year correlation between 20 Year U.S. Treasury Bonds and: U.S. Real Estate −0.22; Commodities -0.22; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.
Do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between the 20 Year U.S. Treasury Bonds and U.S. Municipal Bonds is only 0.37. So there is still value in diversifying within the asset class.
Of course, you also need to factor in asset risk (standard deviation) and expected annual return in your portfolio calculations. Adding a high risk, low return asset to your portfolio simply because it has a low correlation may not be wise.
The Magic Number
Accumulators should include a percentage of investable assets in fixed income. For diversification, if for no other reason.
Also, fixed income may be a good place to park cash as financial objectives approach. You may tolerate high volatility in equities for retirement 30 years away. But perhaps you need a down payment on a new home in 6 months. Shifting assets to cash or lower risk bonds may be the wise move as objective due dates approach. When you seek certainty and safety over potential return and risk.
However, parking assets in cash or bonds for near term objectives should not reflect your general target asset allocation.
Another consideration for Accumulators may be zero coupon (aka strip or deep discount) bonds. Little or no interest is paid out. But you are able to buy an asset, with a known future value, with very little money. And very little money is common for Accumulators.
For example, a 30 year zero coupon bond yielding 3.0%. You can purchase a $100,000 bond for about $41,000. Not bad if you do not need the cash flow until retirement. The higher the interest rates and longer the term, the lower your outlay. A $100,000 zero coupon, 40 year bond at 5.5% would only cost about $12,000.
That longer time horizon is why zero coupon bonds may be better for Accumulators than older investors.
There are pros and cons to zero coupon bonds. Big con is no interest payments, yet you may still be liable for tax on the deemed interest income each year. If investing, do so in a tax-deferred or tax-free investment account. Also, you need to consider future inflation. At current 3.0% yields, given historic inflation rates, your real return over time with a zero coupon bond may be poor (or worse). But perhaps at 5-10% rates, these bonds become a nice addition to your portfolio.
Most Accumulators should not invest more than 50% of their investable assets in fixed income. I likely would not recommend 50% in fixed income even after backing out one’s cash equivalent component. The time horizon for most Accumulators is so long that investing in riskier assets, with higher long-term expected returns, makes more sense.
For the generic Accumulator, I might recommend somewhere between 5%-25% in fixed income. This assumes someone with a moderate risk tolerance and whose cash component, as a percentage of total wealth, is roughly 15-20%.
It also assumes that the fixed income itself is diversified. Which should be done when investing in any asset class.
Where you fall in this range will depend on your risk tolerance and amount invested in cash.
We shall break here for today. Next week, a look at fixed income allocations for Consolidators and Spenders.
by WWM | Mar 13, 2019 | Cash Equivalents, Target Asset Allocation
In Asset Allocation: Cash (Part 1), we saw how your life cycle phase and risk tolerance significantly impact your target asset allocation to cash equivalents.
I do not think it prudent to allocate a percentage of capital to cash. Better to determine a fixed amount you wish to maintain in cash. Then translate into a percent allocation for your overall target asset allocation.
The amount of assets you keep in cash depends on a few factors.
Needs and Opportunities Impact Cash Allocations
Cash for Planned Needs
Regardless of life cycle phase, allocate fixed amounts based on your needs and desires.
1. Determine what you want to maintain in emergency funds.
Funds that will cover 3-6 months fixed expenses.
If you have a solid asset base, then you probably own some lower volatility, higher liquidity, investments. Many people use these rather than pure cash for their emergency funds. Slightly more risk than cash, but also slightly higher returns.
2. Add in any money needed for planned short-term expenditures.
For Accumulators, this might be vehicles, wedding, children, debt repayment, etc. For Consolidators, a larger home, cabin at the lake, extra car, etc. For Spenders, vacations, known medical work, etc.
Cash for Unplanned Expenses
3. You might want to include a reserve for unplanned expenditures as well.
This may be especially prudent for Spenders. With no income other than savings and pensions, having cash available for unexpected costs (e.g., medical) may be wise.
But it may be a consideration for others as well. If personal circumstances dictate (e.g., health issues, young children, lack of medical or dental coverage at work, live in a location with violent weather, etc.) you may want to maintain a reserve for unplanned expenses.
Cash for Opportunities
4. Include a cash reserve for any investing opportunities that arise.
Always useful, but an area many people forget about.
It is nice to have free cash on hand should an interesting investment opportunity arise. Rather than not having the cash and missing out. Or having to sell another asset, incurring transaction costs and possible tax triggers, in order to invest in the new opportunity.
I suggest that this be an amount equal to what you may typically invest in any one asset. If you only invest $1000 at a time, that should be adequate. But if you normally invest in lumps of $20,000, your reserve will be higher.
Risk Tolerance and Personal Circumstances Affect Cash Allocations
How much you allocate to cash in each area will depend on your unique requirements.
If you work in a volatile industry with frequent layoffs, you may want to keep 6 months expenses in an emergency fund. If you work in a stable job, 3 months may suffice.
If you live in a hurricane belt, you might want to maintain some reserves for potential home damage and disruption of life.
How much you allocate will also be based on your personal risk tolerance.
The risk averse might want to save 6 months expenses regardless of how stable their employment is.
Aggressive individuals may want to keep little, if any, reserves for emergencies. Or the more aggressive may want to maintain their cash reserves in more risky cash assets such as foreign currency or short-term corporate paper.
The potential permutations are endless.
Once you total the above hard costs and factor in your risk tolerance, you will come up with the necessary cash component. Based on your total wealth, that will be the percentage that you need to allocate to cash equivalents.
As your circumstances change, while your needed hard costs may be the same, the percentage allocated to cash will shift.
Next, a look at fixed asset allocations.
by WWM | Mar 6, 2019 | Cash Equivalents, Target Asset Allocation
Your target asset allocation should be unique. Driven by your comprehensive investor profile.
As such, you will need to come up with your own personal asset allocation formula. But perhaps I can offer some advice.
Today we will look at cash equivalents.
A big part of an investor profile is dictated by your current phase in the life cycle.
For a refresher, please read Life Cycle View of Wealth Accumulation.
Cash and Cash Equivalents Recap
In general, cash equivalents, including money market instruments, are low risk and low return investments. They are typically highly liquid and stable assets. For a little more detail, please review Cash & Cash Equivalents.
But as we have seen, within this asset class there are also high risk investments that may lack liquidity. Be careful.
Cash equivalents are useful for maintaining emergency funds.
Cash is a good investment for any short-term personal objectives (e.g., vehicles, housing, weddings).
Cash is also needed to cover short-term obligations in full, or as part of periodic payments (e.g., loan repayments with interest).
As short-term objectives and obligations approach, you can shift assets from less liquid and more volatile investments into liquid and stable cash assets. Do not wait too long to shift to cash. Otherwise, you may receive less than optimal value on disposition due to the asset’s liquidity and risk.
Finally, maintaining a portion of capital in liquid assets is useful to take advantage of sudden investment opportunities.
Cash for the Accumulator
Accumulators are typically young people starting out in life. Or individuals who have experienced a disruption in the normal cycle. Those who have been unemployed, out of the work force for personal reasons (e.g., injury, illness, raising a family), or new entrepreneurs.
In this phase of life, cash requirements may be high as individuals often accumulate 3-6 months emergency funds, begin families, and repay relatively high debt loads. All during a phase where income levels are relatively low.
There likely will not be much excess disposable income with which to invest for retirement. After liquidity allocations, what little one has to begin long-term investing probably should not be placed in cash equivalents.
This is because young investors have a long time horizon until retirement. They can prudently accept higher risk in their investments in order to pursue higher returns. Also, Accumulators will have a relatively high percentage of current wealth allocated to cash anyway. Money that is in emergency funds and available for short-term requirements.
As such, it is hard to estimate what young investors should maintain in cash. Many models suggest 5-25% of total assets in cash for investors with greater than 20 years until retirement. The lower end for aggressive investors, the higher end for conservative.
But perhaps you only have $30,000 in assets. Monthly expenses for rent, food, et al., are $2500 and you want to maintain 3 months of expenses in emergency funds. That equates to 25% in cash and does not even factor in any short-term objectives or payments due. Even if you want to be an aggressive investor, you may need a higher cash allocation until you attain a critical mass in your wealth.
For those who are extremely risk averse, 25% in cash might still be too aggressive for their personalities. They might want to have up to 100% of their assets in cash equivalents. Not what I would recommend for most investors developing a long-term investment strategy, but it might be appropriate for those with absolutely no risk tolerance.
As an aside, some investors maintain their emergency funds in investments other than cash equivalents. They accept some risk – potentially reduced liquidity and loss of capital – in order to generate higher potential returns. We are not talking venture capital. More like short term bond funds or even some lower risk equity funds.
Cash for the Consolidator
Typically, consolidators are individuals in the middle of their careers, probably in their mid 30s to late 40s or early 50s.
Income is relatively high and expenses are low. Personal wealth has increased and debt significantly reduced. There is excess cash available for serious investing.
Individuals should still maintain cash in an emergency fund. But given the level of savings already generated, it may not need to be 6 months worth. And, as a percentage of one’s overall allocation, it will probably be small.
In the example above, the person only had wealth of $30,000. So $7500 in emergency funds equalled 25% of total assets. But if the individual now has $300,000 in assets, a mere 5% allocated to cash for emergencies would be $15,000. Double what was put aside in the accumulation phase. If one maintains the same $7500 in reserves, the percentage allocated to cash falls to 2.5%.
As you can see, the percentage of assets allocated to cash must take into account both your potential hard dollar needs as well as your total wealth.
Consolidators may require additional cash for short term objectives. Buying a vacation property, taking a major vacation, paying for the education of children. Or even just generally upgrading one’s lifestyle with a larger home, better vehicle, and new wardrobe.
As this phase of life will see the bulk of one’s investing, it is also a good phase to maintain some free cash reserves to take advantage of opportunities that suddenly arise. Without available cash, an investor will either need to miss out on the investment or have to liquidate other assets to invest. In selling other assets, an investor will pay transaction fees. The investor may incur taxes on capital gains or face losses if forced to sell something prematurely.
Cash for the Spender
Spenders are those at or near retirement age.
Income will be low, but so too should be one’s fixed expenses. By now, people in the spending phase should have accumulated a relatively large amount of capital.
Because accumulated wealth is high, the percentage allocated to cash equivalents may be low. For example, with $2 million in assets, a reserve of 1% would still be $20,000.
But while mandatory expenses may be low, retirees usually want to enjoy life. With increased leisure activities (e.g., vacations, dining, entertainment), discretionary expenses may result in a desire for greater liquidity and ready cash.
While in their 30s, planning retirement needs, many forget about leisure. They factor in fixed costs, but do not include the increased discretionary spending that comes when retirees want to enjoy their free time. Without doing so, retirees may have enough money to live comfortably, but not enough to travel the world or engage in other more expensive pursuits.
Also, with little to no income, many individuals in the spending phase will have substantially less risk tolerance. They will want to allocate higher amounts to cash as protection in case of emergency (e.g., health issues, stock market crashes).
As you can see, your unique personal situation and risk tolerance will dictate what percentage of funds should be allocated to cash equivalents. And, as circumstances change, so too will your asset allocation percent and/or amounts.
In Part 2, we will summarize and look at the key points to focus on for your cash allocation calculation.
by WWM | Feb 27, 2019 | Asset Classes, Risk, Target Asset Allocation
The core asset classes have general risk-return characteristics.
The greater an investment’s risk, the greater the demanded return by investors.
Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.
But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.
We will look at a few examples today.
Cash and Cash Equivalents
In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.
But not all cash equivalents fit this profile.
For a U.S. resident investing in short-term U.S. Government Treasury bills, those characteristics hold true.
High Risk Countries
But the Venezuelan bolívar is also cash. For a U.S. resident investing in bolívar during 2018, the hyperinflation in Venezuela made this currency worthless.
Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentines, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentines awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.
What did that mean?
If you bought a USD 600 television imported from America, it cost 600 pesos in December 2001. Less than a year later that same purchase cost 2400 pesos.
Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.
Even Low Risk Countries
If you think it is simply countries such as Venezuela and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.
For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.
And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.
Two highly regarded currencies. Yet not a low risk, low return investment, was it?
When investing internationally, whether to hedge your foreign currency is always a concern. There are pros and cons to hedging (or not). What is preferable for one investor will differ from the next. And there are multiple variables that require consideration before deciding if hedging is right for your portfolio.
Fixed Income
Fixed income securities are generally considered to be higher risk and higher return than cash equivalents. But lower risk and return to common shares.
Yet again, individual fixed income securities can differ from this generality.
Credit Rating
Fitch Ratings classifies the “safest” bonds at AAA. Lowest investment grade bonds are BBB. Bonds in default are rated D.
As you would expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.
Conversely, the greater the risk that the bond issuer will be unable to pay the interest and principal, the more incentive is required to attract investors. That incentive could involve “sweeteners”, though often it is simply offering higher yields.
For example, consider four bonds, maturing in 18 years, with no sweeteners or provisions. Data as at February 26, 2019.
Government of Canada 5.00% 01-Jun-2037 are rated as AAA. The yield to maturity (YTM) is 2.074%.
Hydra One Inc. 4.89% 13-Mar-2037 are rated as A (High). The YTM is 3.628.
Bell Canada 6.17% 26-Feb-2037 are rated as BBB (High). The YTM is 4.258%.
Shaw Communications Inc. 6.75% 09-Nov-2039 are rated as BBB (Low). The YTM is 4.834.
You can readily see, as the risk of default increases, the yield to maturity required by investors also rises.
Equities
Of the three core asset classes, common shares traditionally have the highest risk and return.
But this may not always be true.
Other Asset Classes May Outperform
We looked at some fixed income yields above. Assuming a hold until maturity, yields between 2% and 4.8%. Relatively safe, but also relatively low return.
What if we compare this to Canadian equities?
On February 27, 2018, the TSX Composite closed at 15,671.15. On February 25, 2019, it closed at 16,057.03. A one year return of only 2.68%. Lower return than many bonds, yet much higher risk.
Of course, one year is a very short time frame. Too short to properly assess higher risk assets. Over the 10 years ended February 25, 2019, the TSX Composite earned investors more commensurate average annual returns of 7.31%.
Never focus on short term performance for higher risk investments.
Differences Within the Class
Of the three core asset classes, there are the most subclasses within common shares.
Mega cap shares will normally have less risk and return than micro or nano cap companies.
Value stocks may be less volatile than growth stocks.
Dividend producing companies may be lower risk than capital appreciation shares.
Foreign companies may have more risk than domestic.
Defensive stocks may be less risky than cyclicals.
Mining companies may be riskier than utilities.
Or, depending on economic conditions, the opposite may be true.
The individual common shares you select will have a different risk-return profile than common shares as a whole.
That is why investors often diversify through multiple subclasses, to spread the risk. Or purchase exchange traded or mutual funds, that usually contain a substantial number of individual investments to diversify risk somewhat.
That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But the ability to time the market is not easy and the transaction costs can be steep. Many investors get the timing wrong and end up costing themselves return.
Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.
There are many other examples possible, but this gives you an idea as to what I am saying.