You have defined a target asset allocation. How should you now build your investment portfolio? By investing in non-diversified, individual assets? Such as common shares of Apple or Tesla. Or is it wiser to invest via well-diversified investment products? Such as mutual or exchange traded funds.
This is a “build your own” portfolio approach. You analyze potential investments across various asset classes and subclasses. Then invest in securities deemed “best in class” to fill out your target asset allocation.
In theory, as you only own the “best” investments in each class, maybe shares of Apple, Google, or Netflix for equities, you should create a strong portfolio. One that outperforms your benchmarks.
Whereas if you bought a S&P 500 index fund, you purchased 500 different companies, whether you want them or not. Great to hold Facebook, Apple, Netflix, and Google in the fund. But you also “own” Norwegian Cruise Lines, Carnival, and United Airlines. Companies whose shares plummeted in 2020 due to COVID.
By owning the “FANG” stocks and avoiding the cruise lines, you would have beat the index return.
Makes a lot of intuitive sense. And the main marketing tool from active asset managers.
This is a doable approach if you have the critical mass of capital to diversify across your target asset allocation. If you are a High Net-Worth Investor, a “build your own” portfolio can make sense.
It may also be a good approach for active traders. Who create non-diversified portfolios and like to jump in and out of specific positions. Or for those who like to tactically invest or engage in market timing. Utilizing a portfolio of individual securities may be a positive for these investors.
Okay, that sounds quite easy. Investing in individual securities is definitely the way to invest.
But it is not that easy in practice.
“What are the potential problems with investing in individual securities?”
While doable, it may not be practical for many investors.
Retail investors may lack the critical mass of capital to manage this approach effectively and efficiently. Though, often smaller investors can find cost effective ways to help acquire common shares. Dividend Reinvestment Plans tend to be very useful.
Can you manage investment fees? If you need a minimum of (say) 30 equities, 15 bonds, and some cash, transaction costs can add up over time as you build or adjust positions. It is much more cost effective to invest $100,000 at a time in an investment, as opposed to $300.
You may also trigger taxable events in buying and selling individual securities.
Can you consistently pick the winners? There are a lot of asset classes and subclasses. With a myriad of individual investments in each. How do you find the “best”? An issue we will cover in future episodes.
Can you manage the opportunity cost? The time required to monitor and amend the portfolio. You cannot simply buy a stock and forget about it. Quality changes over time. Better investments may emerge. If you have a portfolio of 50 assets spread globally, that may require significant time. Do you have the spare time to deal with the portfolio? Or hire someone who does?
Can your properly diversify your portfolio with 50 assets? Investment theory says yes, but you need to do a good job combining asset correlations to create an optimal portfolio. The less securities, the more challenging it will be.
All of these are potential disadvantages in individual securities. But the difficulty in optimally diversifying may be the biggest negative. The greater the number of investments required to diversify is what causes problems in the other areas. With investment expenses, having to consistently find winning investments, and the ongoing time required to manage the portfolio.
What are open-end and closed-end mutual funds? How are they similar? How do they differ?
What about exchange traded funds (ETFs)? How do they compare to open and closed-end mutual funds?
And hedge funds? Is that something retail investors typically use?
If you want additional detail on these different investments, please read “Investment Funds”.
“What are some of the pros and cons of investing via funds?”
Unsurprisingly, many of the potential disadvantages associated with individual securities are positives in investment funds. Investors do not need much money to invest. Well-diversified products. Many are low-cost for investors. Actively managed funds are run by investment professionals. Investor portfolios will have very few investments versus an individual approach. Much less time commitment to monitor.
And the advantages of associated with individual assets tend to be potential concerns with funds. You may not own exactly the securities you want. If you passively invest, you will own the entire index. If you invest in actively managed funds, there may be some fund holdings you do not like.
This episode provides more of a high level comparison with the funds available for investors. We will dig much deeper into investment funds in upcoming episodes. Especially, the potential advantages and disadvantages of open-end mutual funds and ETFs versus individual securities. And in comparing mutual funds against ETFs as investment vehicles.
What is the Equity asset class? Why invest in common shares? How does your life cycle phase, personal circumstances, and risk tolerance impact your target asset allocation to equity investments?
Then we drill down into the diversification and risk-return characteristics of various equity subclasses.
For example, investing by style. Value versus growth investing. Maybe your focus is on generating dividend income rather than capital gains. Perhaps you want to invest based on market capitalization. Mega companies like Apple, Nestle, and Toyota. Or down to small, micro, or nano capitalized companies.
I discuss differences between domestic and international equities. How the risk-return profile and asset correlations differ between developed, emerging, and frontier capital markets. There may also be differences between developed markets, such as EAFE (Europe, Australasia, Far-East) and the US. As well as between individual emerging markets. India and China are much different than Colombia or Qatar.
Not all equities are equal. Two investors may have the same percent allocated to equities. But the characteristics of that allocation may be vastly different.
Note the difference between “global” and “international”. Domestic equities are from your home market. International equities are from around the world, excluding your domestic market. Global include both domestic and international securities. Useful to remember when assessing investment products.
Next we move back into how your life cycle phase affects your equity asset allocation.
“How should Accumulators utilize equities in portfolios?”
Because Accumulators tend to be young, they have a very long time horizon for investing. At least, for the major goal of retirement. The time horizon means Accumulators can handle enhanced portfolio volatility and expect higher returns over time. This suggests heavy exposure to equities.
For many Accumulators, “heavy exposure” means a 100% equity allocation in their early years. However, as discussed with cash and fixed income, there are other factors that recommend some allocation to the other classes. Diversification benefits and short term objectives are two good reasons.
“What about those in the Consolidation phase?”
Consolidators still have a relatively long time frame until retirement. That suggests equities.
However, Consolidators may have more near term objectives and may now decide to focus on diversification as they have more wealth accumulated.
Because Consolidators do have some capital built up, they have the critical mass to better diversify into niche equities than do Accumulators. An Accumulator be may smart to invest in a cost-effective global equity fund as they build an investment foundation. A Consolidator may look for specific investments to improve diversification or try and take advantage of current trends.
Consolidators may have similar equity allocations as Accumulators, but the breakdown within the equities may differ.
“And for those in their Spending phase?”
As you might guess, being at, or near, retirement age means some shift to safer, more liquid assets. Such as fixed income. So the equity allocation is usually lowered when people become Spenders.
But there can still be a long time period to live. With people often living into their 90s, investors might have 30 years to live off their wealth. With inflation and low returns on fixed income, that means Spenders may still need a decent equity allocation.
But the allocation with equities may change. Instead of higher risk frontier markets or micro-cap investments, there may be a shift into more Blue-Chip investments. Or value stocks that generate dividend income, but still have upside capital gain potential.
“How does an investor’s risk tolerance factor in to the target allocation?”
In two key ways, as we saw above in the examples.
One is in the overall equity target allocation. A person’s circumstances or risk tolerance will drive the overall equity allocation.
If you are young, with a long time horizon, accepted investment theory might suggest 80-90% in equities. Whereas, for retirees, maybe a general level should be 50-60%, then adjusted down as years pass.
Also, what is the overall level of wealth. If you have $10 million in assets and only need $50,000 a year to live on, then you can take a low risk allocation with little allocated in equities. If you have $500,000 saved and require $50,000 annually, then you will need to take on more risk.
That is more the unemotional, rational approach to risk and an equity allocation.
However, your emotional view of risk may adjust the equity allocation further.
For some retirees, 50% in common shares may be too high for their comfort. And ability to sleep at night. They may prefer the safety and stability of cash or fixed income over the higher volatility of shares. Likely, these same investors had relatively low equity allocations even in their younger years. Some people are simply more risk averse than others.
Two is the equity investments within the equity allocation itself.
Do you prefer relatively lower risk equities? Blue-Chip companies. Value stocks. Dividend producers.
Do you gravitate towards higher risk investments? Micro-cap stocks. Growth. Frontier markets.
What about the investment itself? A well-diversified global equity fund. Versus individual companies. Maybe with a focus on small-cap mining companies operating in Africa.
The risk-return profile can vary wildly within an asset class. Your personal risk tolerance will dictate the way you invest within that class. And that can create much different risk levels for the overall portfolio.
A relatively short, but good overview of equity considerations in your target asset allocation. Very useful to compare the life cycle phases between cash, fixed income, and equities. Also, how both your personal financial situation and risk appetite will impact your equity allocation. As a percentage of the entire asset allocation. As well as the riskiness inherent in the equities themselves.
What is the Fixed Income asset class? Why invest in fixed income, such as bonds and preferred shares? How does the phase of your life cycle, personal circumstances, and risk tolerance affect your target asset allocation to fixed income?
Fixed income issuers often attach special features, usually called “sweeteners”, to make an issue more attractive to investors. If you want to learn about a few common features, please read, “Key Bond Features: Part 1” and “Key Bond Features: Part 2”.
“How should those in the Accumulation phase of life assess fixed income portfolio allocations?”
Accumulators are relatively young, just starting their careers. With little wealth to invest, what should they allocate to fixed income?
Given that Accumulators tend to have longer time horizons and can handle asset volatility, then relatively lower volatility fixed income, with its low-return, may not be best allocation. At least for the assets not targeted to shorter term objectives.
While fixed income is currently useful for its diversification benefits combined with equities, a heavy allocation here for Accumulators is usually not warranted. But, as we will see below, other factors may arise that make relatively more fixed income prudent.
“What about Consolidators? How is fixed income for them?”
Consolidators are in the sweet spot of their earnings and careers. With a relatively long time horizon until retirement, there is still no real need to shift into low-risk, stable assets.
Again, fixed income is more a diversification tool than an investment to generate returns. That said, in times of falling interest rates, fixed income can offer some very healthy returns.
There may still be a role for shorter term objectives, where they do want that certainty and liquidity. As well, as Consolidators approach retirement age, then adding to the fixed asset allocation may make sense.
“What sort of fixed asset allocations for Spenders?”
Spenders are at, or near, retirement. They rely on pension income, supplemented by cash flow from investments. At this phase of life, there is more interest in stable, liquid investments. Like fixed income.
The problem for Spenders is that people continue to live longer. Investors used to allocated 80-90% in fixed income and cash equivalents upon retirement. But that assumed retirement at 65 and life ending at 72. Fine if there is only 7 years remaining.
People now often live into their 90s. If your time horizon is 30 years, trying to do so with a 90% fixed income portfolio may be difficult. You likely want to still invest in higher risk (higher return) equities as you need to grow your assets. As well as to keep ahead of inflation, which often ravages fixed income yields. For today’s 65 year old investors, 30-40% in fixed income might be warranted. Then slowly adjusted upwards as the years pass by.
“What about personal circumstances and its impact on allocations?”
Identical issues as with cash.
Everyone is in a different situation. That will impact the optimal fixed income asset allocation.
Perhaps you require a fixed amount monthly for living expenses. Or have health issues that need to be addressed. Your personal status will determine, to some extent, what you need in monthly net cash inflows and asset safety. In turn, that will dictate the asset allocation and specific investments to best meet that cash flow requirement. In interest or dividends. Or possibly in an annuity.
“And investor risk tolerance? Does that affect the target asset allocation?”
Your personal risk tolerance also guides your investment decisions.
Some young investors prefer no allocation to fixed income. They want all their capital invested in higher return assets. The benefits of diversification are less important to them than higher expected returns. With long time horizons to manage volatility, this may be reasonable. But likely less than an optimal portfolio should hold.
Conversely, other investors may prefer safety and stability in their portfolios, regardless of age and personal situation. Again, their risk tolerance may create a desire for more fixed income than is optimal.
In most cases, risk tolerance is more emotional. Based on factors such as personality, past experience, etc. Much less on taking a purely ration approach to risk management. To refresh on investor risk issues, please refer to “What is Your Risk Tolerance?” and “Investor Profiles”.
As with cash, there are some generalizations that are useful for investors to factor into their own target asset allocation. But there are also unique, personal aspects that will alter that general allocation.
That is why it is crucial for investors and/or their financial advisors, to develop comprehensive Investor Profiles before beginning the target asset allocation. The unique circumstances of the investor must be factored into the allocation equation. Otherwise, a poor investing plan will be created.
What is a Target Asset Allocation? Why should your asset allocation directly reflect your Investor Profile? And be unique to you? How does portfolio diversification and asset correlations fit into creating an efficient and effective asset allocation? What asset classes and subclasses make up the asset allocation?
Perhaps you decide your allocation should be 70% Equity, 25% Fixed Income, and 5% Cash.
Then you may want to break that down further by asset subclasses, investment styles, etc.
“How does the Investor Profile dictate the appropriate target allocation?”
Your Investor Profile should directly drive your asset allocation.
The Profile reflects you as a unique investor. Your personal financial circumstances and expectations. Where you are in the life cycle phase. Your financial objectives and any personal constraints that may be in the way. The time horizon for those goals. Your risk tolerance. And any other factors that may impact your plan to accumulate wealth and reach your goals.
Together, they should define your Target Asset Allocation.
“Why should a Target Asset Allocation be unique to each investor?”
We just saw all the variables that go into an Investor Profile. If you look at your life and compare it with family and friends, are you all identical? Doubtful. So why should you have the same asset allocation?
Or an asset allocation determined by a “cookie-cutter” formula?
Too many asset allocations are overly simplistic. At one point, it was common practice to recommend that investors subtract their current age from 100 and that is the equity allocation. Another one tends to be a standard 60% Equity, 40% Fixed Income balanced portfolio approach until retirement. Today, there are many Target Date Retirement funds that also use a general formula (often 80% equities until approaching the target date, then they begin to rebalance down).
If you are 30 years old, a formula may tell you, 60, 70, or 80% in equities. In some sense, I get it.
But that fixates on your retirement time horizon.
What if you are 30, recently married, with a new child? Maybe you want to purchase a bigger home in a year or two. Set up an education savings plan for your child to go to post-secondary school. How you invest for near and mid-term financial objectives is not the same as with a 40 year time horizon.
Your asset allocation should reflect your unique situation. Not a “one size fits all approach.”
“How does portfolio diversification fit into creating an efficient and effective asset allocation?”
Creating a well-diversified portfolio is extremely important.
The key to effectiveness and efficiency lies in the correlation coefficients that exist between portfolio holdings. That is the way investors manage investment risk.
And do not forget that asset correlations, and resulting portfolio efficiency, can change over time. As discussed in, “Shifting Diversification Benefits”.
“What asset classes and subclasses typically make up a target asset allocation?”
We discuss a bit more on the core asset classes: Cash and Cash Equivalents, Fixed Income, and Equity.
We did a general overview of this section in “Episode 23: Asset Classes”. On this page, there are links to the intricacies within each of these core classes.
In Episode 24, we touch more on asset subclasses considerations. Also, whether you might need alternative assets classes for added diversification benefits in the portfolio.
In creating a target asset allocation, we must decide on the asset classes to utilize. What are the core asset classes? What are the general risk-return characteristics in each main class? What about asset subclasses? Why is there so much variance in risk-return within a specific asset class and subclass?
“Are there any themes or commonalities between the core asset classes?”
We discuss the general characteristics between asset classes. As well, how there is significant variance in the general traits within each specific class.
That asset classes and markets tend to be quite efficient. From a investment risk and expected return perspective. So you find that cash is generally the lowest risk (and lowest return) of the asset classes. Because of the certainty, the liquidity, etc., of low risk assets.
“What are the key points in Cash and Cash Equivalents (CCE)?”
We review why cash is so important in a portfolio. Even though it has relatively low returns.
If you want to learn a little about different features that may be attached to bonds, please read, “Key Bond Features: Part 1” and “Key Bond Features: Part 2”. Bond issuers often attach special features to sweeten the offering for investors. And those features may impact the offering’s risk-return relationship.
As you can see, fixed income is much more complex that it may seem at first look. With many different risk-return aspects within the asset class itself.
“What are the key points to Equities?”
Equities may be more complex than fixed income. Even if we only look at common shares.
First, there is the general equity versus fixed income versus cash considerations.
But then there are the multitude of equity subclasses.
For example, investing in equities by style. The value versus growth investing considerations. Maybe your focus is on generating dividend income from equities rather than capital gains.
Perhaps you want to invest based on a company’s market capitalization. Mega companies like Apple, Nestle, and Toyota. Or all the way down to small, micro, or nano capitalize companies.
You can invest by geography. Country or region. Domestic versus International. Developed versus Emerging Markets. Maybe you want to hedge your foreign currency exposure on international equities or perhaps take on the currency risk.
You can invest in sectors and industries. You can invest in specialty niches, such as Environment, Social, and Governance (ESG) or Fintech. Both are hot investing niches currently.
Whatever interest you have, there is probably an equity subclass or investment available. And each has a somewhat unique risk-return profile and asset correlation between other equity subclasses.
This video is a nice overview of the asset classes. When we get into the target asset allocation and actual investments to include, we will revisit some of the core asset subclasses.