by WWM | Aug 7, 2019 | Portfolio Review
You should review your portfolio periodically. The timing based largely on your portfolio and asset risk.
But what should you look for?
Portfolio performance is one key area. Both income and capital gains.
To assess performance, a benchmark to compare your results is required.
What is a Benchmark?
A benchmark is any figure against which you use to measure your portfolio’s performance.
The chosen benchmark can be a variety of figures. Or it can be a combination of multiple factors. We will review some common benchmarks later.
Keys to a Good Benchmark
The benchmark should accurately reflect your portfolio and personal circumstances.
Relating to the portfolio, the benchmark should reflect the type of portfolio holdings, including asset class, international exposure, and maturities. Also, the management style, portfolio risk, currencies, etc.
Personal circumstances may include investor objectives and constraints, risk tolerance, accumulated wealth, life cycle phase, time horizon, etc.
From a technical perspective, a good benchmark should have readily available data. You can determine the best benchmark in the world, but if you cannot access historic data on a timely basis, it will be of little use.
I think the prime consideration is that the benchmark reflects the risk-return profile of the portfolio. You always want to compare apples to apples, not to oranges. If your portfolio is 100% Canadian equities, using a benchmark of LIBOR interest rates or the Brazilian Bovespa Stock Index may not be overly useful as a comparative.
Selecting a Benchmark
Select a benchmark concurrently with your actual portfolio construction.
It makes no sense to try and identify a relevant benchmark after the fact or during the period. Choose a target at the start of the period and stick with it throughout the time horizon.
Try to maintain the benchmark for a reasonable period. If your personal circumstances change, or you materially alter the composition of your portfolio, then the benchmark should be reassessed. But do not change continuously. If you do, the quality of information you get from comparisons between benchmark and actual returns will be poor.
There are a variety of of benchmarks available or that can be created. Some are quite simplistic, others are extremely complex. The greater the complexity, the greater the amount of work usually required to maintain.
Over the next couple of posts, we will look at a few common benchmarks. I will also provide some suggestions on developing benchmarks that provide quality information, yet do not require too much work.
by WWM | Apr 24, 2019 | Portfolio Construction
We now turn our focus on how to begin actually investing.
That is, how to accumulate bankable assets and create a well-diversified portfolio.
Generally, you have two options when investing.
Either you make lump sum purchases or you engage in dollar cost averaging.
Yes, there are also direct stock purchase plans (DSPP), employee stock purchase plans (ESPP), dividend reinvestment plans (DRIP), convertible debt or equity, etc. But those are relatively minor in the scheme of acquiring bankable assets. We will touch on them separately. For now, let us compare lump sum versus averaging.
Lump Sum Acquisitions
In lump sum investing, you accumulate your capital and purchase 100% of the asset at once. Depending on your cash flow and reserves, you may have the necessary funds in place to acquire all the desired amount up front.
Or you may need to slowly amass cash over time before making the acquisition. If amassing, invest your growing reserves in highly liquid assets (e.g., money market funds, etc.) to earn a little income on your cash reserves while you wait.
Maybe you have the funds in place, but are just waiting and watching for the right time to buy. Perhaps after a correction or when your analysis indicates an upwards price movement is near. In other words, market timing.
For example, on January 1, you have $20,000 and wish to buy 200 shares of Bank of Montreal (BMO) at $99.95 per share. You invest through an on-line broker charging $10 per trade. With the extremely low commission, your weighted average cost (WAC) and adjusted cost base (ACB) is $100 per share.
If you do not have the $20,000 right now, you would save until you do. Then buy all the shares at once.
Pretty straightforward.
An important thing to note is that with most online brokers, you pay one flat fee per transaction. Buy one BMO share for $99.95, you pay $10. Buy 200, you still pay only $10. The more shares you purchase, the lower the impact of transaction costs. A big change from the full service brokerage days.
Dollar Cost Averaging
With dollar cost averaging (DCA), you do not purchase 100% of your desired investment all at once. Instead, you build your investment consistently over time.
Why would you do this? Especially as I just wrote that the more shares you purchase at one time, the less impact of transaction costs on a per share cost basis.
Why you would do this relates to your ability to time the market. Or, rather, the difficulty in timing market movements.
Maybe you do not have the necessary funds to invest up front in a lump sum. Rather than accumulate cash over time and buy 100% of your investment at once, you prefer to buy piecemeal and build your desired position slowly.
Or perhaps you have the cash but want to invest over an extended period. Possibly due to uncertainty over short-term performance of the asset.
Obviously this technique works better for some asset classes (e.g., common shares) than others (e.g., real estate or diamonds – not sure someone will sell you a house or stone, piece by piece over time). So you need to exercise a little common sense when employing DCA.
In our example, you want to purchase 200 shares in BMO. But you do not have $20,000. However, over the next year you will receive $5000 quarterly from a rich aunt. You decide to use those funds to acquire BMO shares every 3 months.
Flat Asset
If the share price of $99.95 stays flat over the year, you will lose a little versus a lump sum investment. That is because of the fixed fee for each trade, regardless of shares traded. If you invest each quarter for one year at a $10 commission per trade, you will pay a total of $40 in fees. Had you bought in one transaction, only $10.
It may not seem like a lot, but over time that extra cost can add up in lost compound returns.
And the more trades required to reach your goal, the greater the commissions paid.
There are exceptions to this. Investing in certain no-load mutual funds directly through the fund company may not trigger any transaction fees. Some on-line brokers waive transaction fees on certain mutual funds and exchange traded funds. Also, enrolment in stock purchase plans and dividend reinvestment plans may also be transaction free.
In a flat market, not much difference between DCA and lump sum. Extra transaction fees and perhaps less dividend income under DCA. But if you are parking your cash will waiting to buy, you may earn some interest income to offset.
Appreciating Asset
If during the 12 month period BMO appreciates in share price, then you lose even more with DCA. Instead of buying all your shares at the initial price of $99.95 per share, you will need to pay more per share as the asset increases in value. With a fixed budget of $20,000, that will result in less shares purchased.
January 1, BMO trades at $99.95 You invest $5007.50 and buy 50 shares with a $10 commission. On April 1, BMO trades at $103.80, so you purchase 48 shares for $5000. On July 1, you are able to buy 45 shares at $110.89 per share. And on October 1, you buy 42 shares at $118.81. At December 31, BMO trades at $124.75 per share.
With DCA, you accumulated 185 shares of BMO at a total cost of $20,007.50 and a WAC of $108.15. Compare this with the initial lump sum investment that brought 200 shares with a $100.00 WAC per share.
Further, at December 31, the lump sum approach shows an unrealized gain of $4950.00. Whereas the DCA method only results in unrealized gains of $3071.25.
In a bull market, lump sum should outperform DCA.
Depreciating or Fluctuating Asset
Where DCA shines though is in down or fluctuating markets.
Say you bought as above, but the share price was $95.46 on April 1, $97.84 on July 1, $92.41 on October 1, and $89.00 on December 31. A more common scenario than watching a stock steadily climb from $99.95 to $124.75 in one short year.
Under DCA, with a $5000 quarterly investment, you would have accumulated 50 shares January 1, 52 shares April 1, 51 shares July 1, and 54 shares October 1. With the price fluctuations over the year, you have amassed 207 shares for your $20,000. More than under the lump sum approach. And with a WAC of only $96.62 per share.
Additionally, the lump sum would show unrealized loss of $2000. But the DCA strategy would have resulted in unrealized losses of only $1280. A much better result in a bear market.
Or even if BMO rebounded to break even of $99.95 per share at year end, DCA wins out. Your lump sum purchase of 200 shares at 99.95 would be equal to your cost. But the 207 shares acquired under DCA would now be worth $20,690, resulting in an unrealized gain.
Is Either Approach Better?
From the examples above, it should be clear that when assets are appreciating, the lump sum method is preferable. And if you are investing, you anticipate asset appreciation over the long term. So an early lump sum may be smart.
But in short to medium terms, there can be significant volatility in markets and asset prices. If you look at almost any stock over (say) a 3 to 5 year period, there will be ups and downs. Stocks seldom move higher in a linear manner. The more risky the asset, the greater the volatility. In these conditions, DCA might be the better wealth building method.
We will look at this issue in a little more detail.
by WWM | Apr 3, 2019 | Equities, Target Asset Allocation
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.
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.