by WWM | Feb 6, 2019 | Investment Policy Statements, Target Asset Allocation
First, you developed an Investor Profile. Step two in creating an Investment Policy Statement (IPS) is your target asset allocation.
How you intend to invest your capital.
As far as actual investing goes, this may be the most important piece of the puzzle.
What is Asset Allocation?
Asset allocation is the process investors use to distribute their investment capital between various asset classes within their portfolio.
The goal of asset allocation is to create a well diversified portfolio. That is, one which effectively reduces the overall portfolio risk while maintaining the expected level of returns.
Asset Allocation Options
Traditionally, capital is allocated between the three core asset classes: cash equivalents, fixed income (bonds and preferred shares), and equities. We have reviewed these core asset categories already.
Within these three core classes are many sub-classes. For example, within equities there are many options including sub-classes relating to: a company’s market capitalization; where they are located geographically; what industry they operate in. Within fixed income, sub-classes include: bond maturity date; credit quality of the issuer; currency.
Although there are three core classes to divide one’s capital, there are a myriad of choices within each category.
A growing number of investors are allocating a portion of wealth to other asset classes as well. Real estate, precious metals, venture capital, and derivatives, are a few such alternative asset classes. Part of the reason is increased investor understanding about the value of diversification. Part is due to the increasing quantity and quality of cost-effective investments in the non-core asset classes.
I think there are pros and cons to investing in alternative asset classes. But for the average investor, they are not a necessary inclusion in one’s portfolio. A few reasons why. But we will save that for later.
Diversification
When allocating funds between various investments, your goal is to effectively and efficiently diversify your portfolio.
We have previously covered diversification. I recommend you quickly review “An Introduction to Diversification” and “A Little More on Diversification”.
In brief, by adding different investments in your portfolio, you can reduce the overall portfolio risk while maintaining the weighted average expected return.
But effective diversification requires a little more than simply adding different investments to the portfolio. They need to be the right kind of investments.
You need to look at the correlation between assets to find the right type of investments.
Correlation is Key
The correlation between two assets tells how much they will move in tandem.
If they are perfectly positively correlated (correlation coefficient of +1.0), the prices of the assets will move together in lockstep. If they are perfectly negatively correlated (correlation coefficient of −1.0), their prices will move in opposite directions. And if they have no correlation (0.0), the two assets will move completely independently from each other.
Why is this the case?
Each asset class has its own unique risk and expected return profile. Asset classes react to stimuli such as changes in the economy, government monetary and fiscal policy, as well as other factors. Depending on the specific class, these factors will impact in different ways.
For example, consider interest rates. As interest rates rise, (non-real return) bond prices fall.
For successful diversification, investors want to spread out their assets so that the same factor does not affect all investments the same way. When one asset class is negatively impacted by a systematic risk, another asset class should benefit from that same factor.
This provides protection to your portfolio.
Yes, you will not fully participate in strong bull markets in any one asset class. But you also will not suffer the full brunt of any asset class specific bear markets.
If we look at asset classes, traditionally there has been a relatively low to (at times) negative correlation between equities and bonds. As bonds increase in value, stocks should perform relatively poorly. And as stocks rally, bond prices should suffer. By allocating capital between stocks and bonds, you protect yourself when either asset class is underperforming.
For an in-depth review of correlations, please read “Diversification and Asset Correlations” and “Asset Correlations in Action”. There is a lot of information and examples explaining the concept of correlations.
Lower the Correlation, Better the Diversification
In assessing the portfolio risk reduction impact that adding a specific asset will have to your portfolio, you must consider its correlation.
The lower the correlation, the higher its risk-reducing impact.
For example, the 2018 correlation between U.S. large cap and U.S. medium cap shares is about 0.90. Very close to perfect correlation of 1.0. The risk reduction benefit from diversifying in this case is poor. As large cap share prices increase, medium cap stocks will rise almost at the same pace. As large caps fall, so too shall medium cap shares.
However, if you allocate between a U.S. large cap and a U.S. bond fund, the 2018 correlation is approximately 0.20. The risk reduction by diversifying is substantial. Or, if you invest in U.S. real estate and emerging market equities, you will see a -0.67 correlation in 2018. Very nice for diversification.
Correlations Change
The level of correlation between specific assets is fluid to some degree.
Correlations can also shift over time in both directions.
For example, in 2011 the correlation between U.S. bonds and the S&P 500 was -0.31. Excellent for diversification. In 2018, that correlation had increased to 0.27. Still useful in building a portfolio, but less so than a few years ago. In 2025, perhaps the increase will continue. Or maybe it will reverse back to negative correlation. Hard to tell.
When conducting your periodic portfolio reviews, always check the correlation between your investments. If the correlations have shifted, determine why. It may be a temporary situation or perhaps it is significant and considered permanent. If the latter, you will need to reconsider your asset mix to ensure optimal diversification.
That is an overview on asset allocation.
We shall continue our look at asset allocation next time.
by WWM | Jan 30, 2019 | Investment Policy Statements, Investor Profile
To create an Investment Policy Statement (IPS), begin with a comprehensive investor profile. Who you are as an investor today. What you want to achieve in the future. The restrictions you may face on that journey.
This requires assessing your current situation. Your finances, as well as investment related objectives and constraints.
But it is also important to factor into your analysis, three additional key variables: investment time horizon; current phase of life-cycle; risk tolerance level.
Time Horizon
We have already reviewed time as it relates to investing in our compound return discussion.
Longer Time Frame, Greater the Risk and Return
The longer the investment time frame, the greater the potential volatility (i.e., investment risk) that can be accepted in a specific asset.
And from the relationship between risk and returns we saw that the more volatility that an asset has, the higher the expected return that should be associated with the investment.
If your objectives are far in the future, you can afford to take on additional risk in the expectation of higher returns. This is because you can ride out the up and down swings over long periods and average out the higher expected return over time.
If you have near-term goals, then you want increased certainty as to the result. You do not want to be caught in a down swing during the initial period when you require the funds. So you willingly accept higher certainty in a lower return investment as an acceptable trade-off.
This is why it is commonly recommended that younger investors invest in higher proportions of equities than in fixed income or cash. And for seniors that require a consistent and constant cash flow to finance their retirements, it is usually recommended that they have most of their assets in fixed income or cash instruments.
Longer Time Frame, Less Capital Needed
The longer you have to invest, the less you need to invest.
Both on a periodic basis, as well as in total.
For example, a 25 year old with a 40 year investment horizon only needs to contribute $315 per month at 10% to accumulate $2 million at age 65. If that same person delays investing until 30, he will need to invest $525 per month at the same 10% return. Wait until age 40 to start investing and he will need to contribute $1500 per month at 10%.
A significant difference in money needed to fund the account each month. And yes, one does expect that as you move from 25 to 40, your monthly income should be higher. But still, the monthly differences likely will not be that great to wait.
As a further incentive to start investing, look at the actual aggregate contributions made by individuals at each age. The earlier you begin to invest, the less total cash you will have to divert from your disposable income.
The 25 year old contributes $151,200 over 40 years to amass $2 million. The 40 year old has to contribute $450,000 over 25 years to accumulate the same $2 million. Again, the power of compounding has a tremendous impact on wealth accumulation.
Phase of Life-Cycle
We have also previously reviewed the life-cycle view of wealth accumulation.
Usually Correlated to Age
The phase in one’s life-cycle is normally linked to age.
When you are young, you are just starting out in the world. Income is relatively low, costs are high. As you get older you begin to accumulate wealth, but costs are still high. As income continues to rise and costs begin to fall (mortgage paid off, no car loans, etc.), wealth accumulation takes off. Then you retire and income falls, requiring the use of savings to make up the shortfall between income and costs.
But Not Always
While this may still be normal for most people, times have changed somewhat.
Increased unemployment may alter one’s progression through income increases over time. More individuals are becoming entrepreneurs which also impacts the normal progression between life and income.
As well, people are getting married later in life and having fewer children. Interest rates on debt are relatively low. There may be less costs for younger adults than in previous decades.
And these are just a few quick examples as to how things are changing. Should inflation increase, as is expected in North America, that will also impact living expenses.
Do not simply assume your investment time horizon and life-cycle phase are connected.
Look at both areas separately when assessing your investment objectives and constraints.
Risk Tolerance
Risk tolerance is another area we have previously reviewed.
The greater one’s risk tolerance, the greater the potential for higher expected returns over extended time periods.
That is not to say, head to Las Vegas and “invest” your money in the casinos. But I am saying that a properly structured investment portfolio should achieve higher expected returns over the long run than the same money being invested in Treasury bills or term deposits.
I understand though that risk tolerance differs from investor to investor. If you are more comfortable in lower risk assets, that is fine. Just realize that you may need to invest more, for longer periods, to achieve your goals.
Investor Profile Drives the Actual Investing Process
An investor’s current financial situation is the starting point to an IPS. But one’s objectives, constraints, investment time horizon, phase of the life-cycle, and risk tolerance really define an individual’s investor profile.
It is important that you clearly understand your own profile. If you do, I think you will make smarter investment choices when managing your own wealth.
It is also imperative that any financial advisor who manages your money also clearly understands your profile. That is why it needs to be discussed and agreed upon in writing, so as to eliminate as much ambiguity as possible.
Your profile will serve to drive the rest of the investment process.
What asset classes you include or exclude. The asset allocation that you choose. The investment styles, strategies, and tactics that you use. So the investor profile is crucial if you want success in your investment plans.
by WWM | Jan 23, 2019 | Investment Policy Statements, Investor Profile
Developing a comprehensive investor profile is the first step in creating an Investment Policy Statement (IPS).
The investor profile documents who the investor is today. As well as where they want to go. This includes the individual’s: financial situation; investment objectives; personal constraints.
Financial Situation
To get where you want to go, you need to know where you are today.
It is easier to accumulate $2 million dollars in 10 years if you have $1 million today. Versus starting with nothing. And it is even easier to accumulate $2 million in 10 years if you begin with $3 million. But one path may be the wiser.
Personal Balance Sheet
Prepare a personal balance sheet listing all your assets and liabilities at market or realizable value. The liquidity of the asset will help determine the difference between market and realizable price.
There will be different liquidity considerations for bankable versus physical assets.
A common share traded on a major exchange should be more liquid than your house or vehicle. The more liquidity, the easier it will be to receive market value. The less liquid, the longer you may have to wait to obtain the market price should you want to sell. Or, the less liquid, the greater you will need to discount the selling price in order to make a quick sale.
The balance sheet provides a snapshot of your net wealth at the date of preparation. It will also provide you with your current asset allocation.
The snapshot occurs at one specific moment in time. You will need to monitor and update your situation periodically.
Be Holistic
Take a holistic view when developing an investment plan.
Often, investors “forget” about non-portfolio assets when calculating their investment strategy. Not forget about the asset, but mentally forget that it is an actual asset that needs to be included in the investment mix. If you own a house, then this is a real estate asset. It needs to be factored into your overall asset allocation plan or you will err in your calculations.
The same goes for assets such as pensions through your employer. You need to know what the pension is invested in, if anything, so that you can complement your own strategy.
Statement of Cash Flow
I also suggest preparing a statement of cash flow. What money is coming in the door each month and what expenses are being paid? Any excess is money available for investing.
More likely though, you will not have much, if any, excess. You should review your cash flows and look for ways to cut back in some expenses in order to generate investment ready cash.
This may require some budgeting work.
If you are not an accountant, no fear. There are a variety of inexpensive and easy to use tools to help create balance sheets, cash flow statements, and personal budgets.
Investor Objectives
We have considered investor objectives already.
Categorize Objectives by Time to Maturity
It is important to segment objectives into the short, medium, and long-term.
While you may not plan to retire for 40 years, you likely have near and intermediate goals that must be incorporated into your total investment planning. A car you want to purchase in six months requires near term financing. And the house you hope to buy in five years needs to be reflected in your IPS.
The closer the objective is in time, the less risk you want to take in the investment.
Categorize Objectives by Priority
You should also label each objective as high, medium, or low priority.
That way, if your wealth accumulation falls short of its targets at various points in life, you can still hopefully hit the high priorities.
Quantify Your Goals
In an IPS, I suggest that you try to quantify investment goals as much as possible.
Simply stating that you want to maximize your investment performance or achieve financial security by age 60 is not enough. It is easier to achieve one’s aims by setting specific and realistic targets. Then work backwards to develop an action plan on how to achieve the goal.
If you believe that you need $2 million in liquid assets at age 65 with which to retire, then you can set up various investment scenarios factoring in time to retirement, after-tax returns, and required contributions.
For example, if you are 25 years old, you have 40 years until 65. If you use a tax-deferred investment plan, you would need to invest approximately the following each month to accumulate $2 million by age 65: $125 at 13% per annum compounding monthly; $315 at 10%; $750 at 7%; $1300 at 5%; etc.
The combinations are endless.
And you can clearly see how the compound performance impacts the overall wealth accumulation. Be certain that every dollar (Euro, Franc, Pound, Yen, etc.) you invest goes toward an investment, not a commission, management fee, operating cost, and so on.
Create Milestones
In addition to quantifying specific goals, you should also quantify milestones along the way. Tracking progress as you work toward the ultimate target allows you to adjust variables and stay on course.
For example, perhaps your goal involves investing $500 monthly for 40 years with a 10% expected return. But over time your actual return is 6%. If you wait until year 35 to review your status, it is too late. There is almost no way to recover without a winning lottery ticket.
If you review after 5 years and find lower than expected returns, then you have more options. Make a lump sum investment to become whole. Increase monthly contributions to $1000 until you are where you should be. Or maybe increase portfolio risk to hopefully outperform moving forward. All have pros and cons, but you will need to adjust.
And for the record, I would recommend annual reviews. Possibly more frequent based on the volatility of your portfolio.
Investor Constraints
Individuals have many things that impact their ability to achieve their investment objectives.
We reviewed investor constraints previously. There are many factors you need to consider in your IPS.
Free Cash to Invest
A major constraint for many people is just in having the money needed to invest for one’s goals.
If you need to invest $1300 per month at 5% to meet your objectives, yet your take home pay is only $2000 per month, you will have problems achieving your investment goals.
An added incentive to begin saving and investing as soon as possible.
Three key variables greatly impact an investor’s objectives and constraints: time horizon, phase of the life-cycle; risk tolerance. We will discuss these keys next week.
by WWM | Jan 16, 2019 | Investment Policy Statements
As discussed in “A Quick Look Back”, we have reviewed many key investment related concepts over the last two years.
Investment risk, expected returns, diversification, asset correlations, risk, return, active versus passive management, and information on the core asset classes.
And much more.
Understanding the core concepts underlying the investment process will help the next steps make sense.
In 2019, we will move to the creation and management of investment portfolios.
The Next Step in the Journey
The next step in developing an efficient and effective investment portfolio is creating an Investment Policy Statement.
Okay, maybe not for most people. This is an investment mechanism that is often ignored.
But it is something that is important for successful investing and should be utilized.
What is an Investment Policy Statement?
You may also see it referred to as an Investment Plan, Investing Strategy, or by other names. And you may see Investment Policy Statement refer to the agreement between a financial advisor and client as to how the client’s assets will be managed. Be aware that the title and content may slightly differ depending on context.
In my world, I will go with the following name and content.
An Investment Policy Statement (IPS) is a written document that defines an individual’s planned investment strategy.
The IPS provides an outline as to how the portfolio should be constructed and managed.
The IPS also serves as an evaluation tool and report card on the performance of the investment portfolio.
Comprehensive Investor Profile
It starts with information concerning the investor’s unique profile.
What type of investor is the individual behind the IPS? What is the investor’s current financial position? What are that person’s investment objectives? Are there any constraints that may impact achieving the stated goals?
Are there any specific investments or asset classes expressly to be included, excluded, or monitored?
The individual’s risk tolerance, investment time horizon, legal situation, ethical concerns, and phase of the life-cycle, are important considerations within the investor profile.
Asset Mix
The investor profile determines the appropriate asset classes for the investment portfolio.
It is also used to develop the optimal target asset allocation in creating a diversified portfolio.
Based on studies, many finance professionals believe that asset allocation explains approximately 90% of the variability of returns in a portfolio. As a result, asset mix is more important than individual security selection in creating effective portfolios.
This is a key segment in the IPS to get correct.
Portfolio Construction and Management
The IPS will define portfolio construction and subsequent management.
Depending on who is managing the portfolio, the IPS may include: creation of investment accounts; funding of the account; use of power of attorneys; asset classes and investment styles employed; process of buying and selling securities; and other related matters.
Should a third party be managing the account, this is a crucial section to agree upon. Otherwise, misunderstandings (or worse) can destroy the business relationship and jeopardize the investment portfolio.
Performance Benchmarks
The IPS should include the agreement of pre-determined benchmarks that will be used to assess portfolio performance.
Benchmarks should directly relate to the target asset allocation and type of investments that will be made.
Review and Remedial Measures
Finally, the IPS should state the process and periodicity for monitoring the portfolio. As well, how to address any deficiencies or adjustments in the portfolio after review.
Importance of a Written IPS
The IPS should be a written document.
It provides a clear and detailed blueprint to follow and a means to evaluate performance.
Maintains Focus
By having it formally documented, it will help keep you focussed on your plan. It will promote a consistent and disciplined investment approach that you require to succeed.
It will also provide support and keep you on the right path during turbulent market times, which occur often.
A formal IPS is important for you in managing your own money. It is even more important when relying on someone else to manage your portfolio.
You must be on the same page as any advisor you utilize. The advisor must completely understand your unique situation and implement the plan exactly as envisioned.
Provides Protection
A written document that has been signed off by both parties provides protection.
It protects the investor against unwarranted moves made by the advisor.
It can also protect the advisor against unhappy investors who may claim negligence where there is none.
Living and Adapting IPS
As you can easily see, your personal investor profile drives the target asset allocation. Which, in turn, drives individual investments, benchmarks, and remedial actions.
The IPS is not a static document. As your life continually evolves and the world changes, your unique investor profile will shift. And your IPS will require adaptation.
Okay, a nice summary of an IPS. We will examine the components in greater detail over the next few weeks.
by WWM | Aug 2, 2017 | Investor Profile
Individuals often consider their goals and objectives when investing, but fail to focus on their personal constraints.
However, investor constraints require equal consideration as they play a substantial role in one’s investment strategy.
Constraints are limitations or restrictions that are specific to each person. Some may be common to many people, others may be unique to that one individual. Today we shall look at a few.
Liquidity Requirements
Liquidity is an investment constraint for most individuals.
The need to always have some cash on hand to deal with daily expenditures or planned purchases necessitates that one avoid certain investment options for a portion of one’s assets.
Three common liquidity needs are emergency funds, planned acquisitions, and investment opportunities.
Emergency Funds
Most investors require a portion of their assets in cash to cover required expenditures, such as mortgage and loan payments, rent, food, transportation and other necessary living costs.
Some experts recommend maintaining 2-3 months spending in emergency funds. In uncertain economic times, when there is a higher risk of employment loss, 3-6 months costs in your emergency fund may be more appropriate.
Another reason for the greater number of months is that many readers are young with relatively low salaries and little in the way of investments or wealth. As you increase your salary levels and begin to build up an investment portfolio, then you may consider reducing your emergency funds to around 3 months of required expenditures.
Short Term Planned Acquisitions
Many individuals plan to make major personal expenditures in the near future. This may be a car, home, travel; anything that requires a large payment at a specific date.
Planned acquisitions require individuals to structure their investments so required amounts are available in cash at the due date. This may result in liquidity constraints as you set aside other funds to make the major expenditure.
For example, investments in venture capital typically have a payback period of between 12 and 14 years. Venture capital is usually an illiquid asset. Therefore, it may be difficult to recover your capital quickly should the need arise.
If you want to maintain $10,000 in liquid assets for emergency funds, you should use it to invest in a venture capital project. In this case, the need for ready cash constrains your investment choices to highly liquid and secure investments.
Investment Opportunities
As you get older and accumulate some wealth, I suggest keeping a small portion of your assets in liquid form at all times. This allows you to take advantage of investment opportunities that may suddenly arise.
If you do not have any liquid assets, then you will have to dispose of another asset in order to purchase the new investment. And when you are forced to sell something at a time other than of your own choosing, often you will not get the best price for it.
But by maintaining about 5% of your wealth in liquid assets, you should always be able to take advantage of interesting opportunities. Obviously, that percentage fluctuates based on your total net worth and desired amounts to hold for unexpected opportunities.
Time Horizon
As we saw in our Life Cycle analysis, investment time horizon can be a plus or a minus to one’s strategy.
As the time horizon until your financial objective decreases, the variety of assets in which to invest also diminishes. Also, the less the time horizon, the less volatility or risk an investor can tolerate in his portfolio.
Tax Issues
After-tax returns are what investors should be most concerned.
You cannot re-invest and earn compound returns on money paid to the government in taxes. Your investment goal should always be to maximize after-tax returns, not gross returns.
Personal Tax Bracket
The tax bracket that the investor is in will impact investment decisions.
If an investor is currently in the highest bracket, she may want to avoid investments that generate taxable income while she is in the top tax bracket. Instead, she may prefer to invest in assets that experience future capital gains. Hopefully, these gains will not crystallize until she has moved into a lower tax bracket.
The same applies to an investor who is in a secondary tax bracket. He may need to be careful about generating too much annual interest or dividend income to avoid being pushed into a higher marginal tax rate.
In both examples, the investors may also be very interested in tax-free investments and/or tax deferred investment accounts. The availability of these investments and accounts varies greatly between tax jurisdictions.
Tax Laws
Tax laws also play a significant role in one’s investment decisions.
In some countries, like Canada, interest income is taxed at a higher rate than certain dividends or capital gains due to tax credits and lower inclusion rates.
If you reside in a country that has different tax rates for different types of investment income, it should affect your investment choices to some extent.
For example, perhaps you live in a jurisdiction where interest income is taxed at a higher rate than dividend income. You have to choose between two investments of equal risk, both offering the same gross return. One pays out interest, the other dividends. You would select the one with the better after-tax return. In this example, the dividend stream.
Many countries offer tax-deferred investment accounts. There are often limitations on annual contributions to the accounts and the possible investments that may be held. Again, this will constrain your investment strategy.
For example, a Canadian Registered Retirement Savings Plan (RRSP) has a 2017 contribution limit of 18% your 2016 earned income, subject to a maximum CAD 26,010. An RRSP will also have restrictions on what investments can be made. A self-directed RRSP provides much more investment latitude than a non-self-directed. But you still cannot hold certain assets such as Bitcoins, uncovered calls, stocks from non-designated exchanges, etc.
Legal and Regulatory
The legal and regulatory environment may also constrain one’s investment decisions.
Typically this is a more important consideration for institutional investors than for individuals. However, there are areas in trusts and foundations where legal issues can be a problem for investment options.
For those of you in public accounting, banking, or law, you may experience issues here.
For example, if you audit a public company, you may be precluded from owning shares in that company. Or if your bank is performing certain work on a company, you may have a blackout period for trading shares in that corporation.
The same may apply in respect of insider trading laws. If you have non-public knowledge, you may run afoul of securities’ laws.
Your sister is president of a publicly traded company and tells you the company is about to be sold for a huge premium. If you go out and buy shares in the company prior to the announcement, you run the risk of being charged with insider trading. You also may run into difficulties if she did not tell you and you coincidentally bought shares a day before the announcement. So whenever there is the potential for issues with an investment, take care.
Unique Circumstances
Finally, many unique circumstances can constrain one’s investment strategy.
Some are self-imposed, others are forced upon the investor.
Certain investors believe in ethical investing. That is, they do not want to invest in companies that they consider unethical. This might include tobacco or alcohol companies.
It may also include companies that operate in certain countries. This was common practice among many investors during Apartheid in South Africa. Today there are countries which by personal choice, or even through laws in some jurisdictions, that prevent individuals from investing in them.
The US currently has legislation that severely restricts trade or investment in Iran. If you try to invest in Iran or Iranian companies, you may be subject to prosecution. Note that this could also be considered a legal constraint.
Other unique circumstances include the ability to purchase certain investments.
For example, a new Initial Public Offering (IPO) may only be available to the best clients of the brokerage house marketing the offering. Or some hedge funds may only be open to investors with extremely high amounts of money. Some mutual funds may no longer accept funds from new investors.
By now you should have some ideas on where you are in life cycle, what some of your investment objectives are, and some of the constraints that you face.
You also may have formed an opinion on your risk tolerance and investor profile.
Next week we will look at asset classes. Probably not too much detail on the actual descriptions, but more how they tie into risk tolerance and one’s investment strategy.