by WWM | Jul 22, 2020 | Target Asset Allocation
Your asset allocation and investment strategy may work well in “normal” times. But how does it perform during a so-called Black Swan event? And what happens if you panic and reduce portfolio risk as the result of crashes?
An article by Jim Otar, “How asset allocation impacts portfolio recovery”, looks at this issue.
A few thoughts on the article from my side.
Markets are Overwhelmingly “Normal”
The media attention is always on the outliers and Black Swan events. Usually to the downside. So it appears huge corrections are fairly common.
Interesting to note that only 6% of the time, markets operated in a fractal mode. The other 94%, markets act in an expected, albeit often random, manner.
As the article points out, proper target asset allocation works well in normal times. You only have issues about 6% of the time. A good reason to “stay the course” and continue with a structured investing approach and plan.
Know Thy Risk Tolerance
True. I think this kind of gets glossed over in the article.
Investors should take a systematic approach to their risk tolerance. At times, this is difficult as emotions and behavioural aspects often intrude.
This is an area where a competent financial advisor can add value. Someone who is dispassionate. Who understands investing and how risk should be assessed within your portfolio.
Risk should not be about gut feelings. Though, they will play a part. If you are someone who is concerned about any minor loss, you will stay awake at nights if invested heavily in equities. So there is that to consider.
But if you learn about the risk-return relationship, portfolio diversification, how asset correlations can reduce overall risk, how time impacts riskiness, etc., that will (hopefully) alleviate some of the less rational concerns.
Asset Allocation and Life Cycle Phase
Part of one’s risk tolerance should be tied to time horizon and phase of life cycle.
If you are earning income and your main priority is retirement in 30 to 40 years, you have a relatively long time horizon. Ceteris paribus, you can invest in higher risk (with higher expected return) assets than someone who plans to retire in 3 to 4 years. Emotion is not involved. Just basic mathematics.
That said, most people have multiple investment objectives. Of varying time horizons. I am 30 and wish to retire at 65. I have a 35 year horizon. Perhaps my target asset allocation should be 80-90% equities.
But perhaps I wish to start a family and buy a home in 3 years. That changes the equation as I want greater certainty to ensure I have a down payment on the home. As well, maybe I want to start an education plan for my newborn. Or I need to consider personal insurance in case of health issues.
Your risk tolerance needs to reflect your investment objectives, their relative priority, and time frame.
Single, 30 year old me can sit tight and ride out any Black Swan events. Because I have a 35 year horizon and I will recover any short term unrealized losses. If I stay the course, I will do better than jumping in and out as the article’s examples show.
However, it is different for family starting 30 year old me. If I need $50,000 as a down payment on a home in 3 years, a Black Swan correction of 25% may not recover in 36 months. In the examples given, my behaviour and investing should be more like a 60 year old. At least for the portion of assets needed for near term objectives.
This is an area I often see problems. Individuals focus exclusively on retirement in 30 years and invest accordingly. But do not account for short term goals that require a different investment approach.
60/40 or 40/60 Asset Allocation Split
The article uses 60/40 or 40/60 equity to fixed income ratios in its examples.
Not too many years ago, a 60/40 split was often recommended for younger investors, with a move to 40/60 as retirement neared. Then, heavy into fixed income after retirement.
I think the author is simply using these splits in his examples. Not recommending them. Do not believe you should use either.
Your target asset allocation should reflect your unique investor profile. Not some cookie cutter approach.
For example, another “great” allocation calculation was to invest (100 minus your age) in equities. The rest in fixed income. If you were 30, that meant 70/30 split. At 40, 60/40. And so on.
Simple, yes. Useful, probably not.
See my comments above on the single 30 year old versus the 30 year old who wants to buy a home and start a family. Should they both have 70% in equities and/or identical portfolios? No.
Your target asset allocation should reflect your unique investor profile. Your financial position and realistic expectations. Where you are in your life cycle. Investment objectives by priority and time horizon. Constraints that may impact achieving your goals. And your personal risk tolerance.
All of these factors will determine the appropriate target asset allocation and drive your investing strategy. What might be optimal for you, may not be for a friend of the same age. As he/she will have a different investor profile. Perhaps similar, perhaps not. But not identical.
As your own personal circumstances change over time, then you will also differ from “past you”. Your investor profile should be updated to reflect those changes. And, as necessary, your target asset allocation and investment plan.
by WWM | Sep 11, 2019 | Portfolio Review, Target Asset Allocation
You should compare your portfolio’s performance against predetermined target benchmarks.
We have already covered a few useful benchmarks.
Arbitrary returns, such as nil, the risk-free rate, or a required rate of return based on your needs.
Relevant publicly available indices that reflect the composition and risk of your actual portfolio. This is especially useful when passively investing in index funds. But there are still a few things to watch out for.
Benchmark performance, fees, and expenses against fund peers and category averages.
Better yet, combine some or all of the above benchmark options.
There is one other important benchmark that we have not yet covered.
Comparing your actual portfolio against your target asset allocation.
Target Asset Allocation
Your Investor Profile drives your target asset allocation.
It should factor in your personal circumstances, financial status, investment objectives, personal constraints, risk tolerance, and so on. As such, your target asset allocation will be unique to your own situation.
As your personal situation changes over time, your target allocation will shift as well. But changes should be made only when material events occur in your life (e.g., marriage, children, inheritance, career change) or when you move through phases of your life cycle. Alterations to one’s target asset allocation should not be an annual activity for most investors.
Actual Versus Target
Some experienced investors may compare the expected returns of their target asset allocation to the actual results. This can be done if you can assign expected returns to each asset class. Many investment companies, research firms, and professional organizations publish forecasts for major asset classes. However, these are far from guaranteed to occur.
Instead, compare your actual asset allocation against your intended allocation. It will not likely be the same.
The reason is that your portfolio will probably earn some income in the form of dividends or interest. You may also buy or sell investments from existing liquid assets. These will all impact your cash component.
As well, you will incur unrealized gains or losses on your investments. These changes will affect your actual allocation.
For example, you invest $10,000 on January 1. Your target asset allocation is 70% global equities and 30% in global bonds. You buy 100 shares of Vanguard Total World Stock Index ETF (VT) at $70 per share and 40 shares of Vanguard Total World Bond ETF (BNDW) at $75 per unit. At year end, you review your portfolio and find that the VT shares are worth $90 each and the BNDW shares at $65.
Based on changes in market prices, your portfolio is now valued at $11,600, ignoring any fund distributions. Although you did not buy or sell any shares or units during the year, your portfolio allocation now sits at 78% equities and 22% bonds. Suddenly, you are out of alignment with your planned allocation.
Good or Bad?
When comparing your actual portfolio performance against an index, peer, or arbitrary value, the higher the better.
But in comparing your portfolio against the target allocation, the less variance the better.
Ideally, you would like your actual portfolio to maintain its target ratio as long as possible. But this is not realistic. In creating a well-diversified target allocation, you may have 4-8 different asset classes and subclasses included. As the investments grow in number, it is pretty certain that your actual allocation will differ from the target yearly.
Also, because a well-diversified portfolio should see some assets increasing in value and others falling as they act as hedges against each other’s movements. That is a purpose of being well-diversified.
So your objective in this analysis is to monitor your portfolio and make sure that it stays within a certain range of your target asset allocation.
Target Range
Range?
Yes, range.
To the extent practical, you want to maintain a buy and hold investment strategy. But if you want to ensure a fixed ratio of 70% stocks and 30% bonds, then you will need to rebalance constantly.
In our example above, that might mean selling shares of VT and purchasing additional units of BNDW with the proceeds to rebalance. That works for now. But what about the next review? What if stocks have fallen in price and bonds have increased? You might find that your VT shares are only worth 50% of your total capital. Then you need to sell some BNDW and buy some more VT. And the next review, things may change again.
Not a formula for successful investing.
Instead, use ranges for your target allocations. Maybe you desire a 70-30 split between stocks and bonds. Fine, but create a comfort zone to prevent frequent adjustments. Especially for price changes due simply to normal asset volatility. Perhaps your target range can be 65-75% stocks and 25-35% bonds. Or 60-80% stocks and 20-40% bonds. Though this latter example may be a tad too wide.
That will give you some leeway during your reviews, thereby preventing continuous adjustments with the attendant transaction fees and taxes on capital gains.
The range you select should reflect your individual tastes. Your investor profile, personal risk tolerance, and ongoing review experience will play a large part in how wide the ranges are.
It should also reflect the volatility of the underlying investments. A blue chip equity fund should be less volatile than a small cap software fund. If you want 20% of your assets allocated to each fund, perhaps your target range for the blue chip is 15-25%, whereas the more volatile small cap could be 10-30%.
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.