by WWM | Mar 13, 2019 | Cash Equivalents, Target Asset Allocation
In Asset Allocation: Cash (Part 1), we saw how your life cycle phase and risk tolerance significantly impact your target asset allocation to cash equivalents.
I do not think it prudent to allocate a percentage of capital to cash. Better to determine a fixed amount you wish to maintain in cash. Then translate into a percent allocation for your overall target asset allocation.
The amount of assets you keep in cash depends on a few factors.
Needs and Opportunities Impact Cash Allocations
Cash for Planned Needs
Regardless of life cycle phase, allocate fixed amounts based on your needs and desires.
1. Determine what you want to maintain in emergency funds.
Funds that will cover 3-6 months fixed expenses.
If you have a solid asset base, then you probably own some lower volatility, higher liquidity, investments. Many people use these rather than pure cash for their emergency funds. Slightly more risk than cash, but also slightly higher returns.
2. Add in any money needed for planned short-term expenditures.
For Accumulators, this might be vehicles, wedding, children, debt repayment, etc. For Consolidators, a larger home, cabin at the lake, extra car, etc. For Spenders, vacations, known medical work, etc.
Cash for Unplanned Expenses
3. You might want to include a reserve for unplanned expenditures as well.
This may be especially prudent for Spenders. With no income other than savings and pensions, having cash available for unexpected costs (e.g., medical) may be wise.
But it may be a consideration for others as well. If personal circumstances dictate (e.g., health issues, young children, lack of medical or dental coverage at work, live in a location with violent weather, etc.) you may want to maintain a reserve for unplanned expenses.
Cash for Opportunities
4. Include a cash reserve for any investing opportunities that arise.
Always useful, but an area many people forget about.
It is nice to have free cash on hand should an interesting investment opportunity arise. Rather than not having the cash and missing out. Or having to sell another asset, incurring transaction costs and possible tax triggers, in order to invest in the new opportunity.
I suggest that this be an amount equal to what you may typically invest in any one asset. If you only invest $1000 at a time, that should be adequate. But if you normally invest in lumps of $20,000, your reserve will be higher.
Risk Tolerance and Personal Circumstances Affect Cash Allocations
How much you allocate to cash in each area will depend on your unique requirements.
If you work in a volatile industry with frequent layoffs, you may want to keep 6 months expenses in an emergency fund. If you work in a stable job, 3 months may suffice.
If you live in a hurricane belt, you might want to maintain some reserves for potential home damage and disruption of life.
How much you allocate will also be based on your personal risk tolerance.
The risk averse might want to save 6 months expenses regardless of how stable their employment is.
Aggressive individuals may want to keep little, if any, reserves for emergencies. Or the more aggressive may want to maintain their cash reserves in more risky cash assets such as foreign currency or short-term corporate paper.
The potential permutations are endless.
Once you total the above hard costs and factor in your risk tolerance, you will come up with the necessary cash component. Based on your total wealth, that will be the percentage that you need to allocate to cash equivalents.
As your circumstances change, while your needed hard costs may be the same, the percentage allocated to cash will shift.
Next, a look at fixed asset allocations.
by WWM | Mar 6, 2019 | Cash Equivalents, Target Asset Allocation
Your target asset allocation should be unique. Driven by your comprehensive investor profile.
As such, you will need to come up with your own personal asset allocation formula. But perhaps I can offer some advice.
Today we will look at cash equivalents.
A big part of an investor profile is dictated by your current phase in the life cycle.
For a refresher, please read Life Cycle View of Wealth Accumulation.
Cash and Cash Equivalents Recap
In general, cash equivalents, including money market instruments, are low risk and low return investments. They are typically highly liquid and stable assets. For a little more detail, please review Cash & Cash Equivalents.
But as we have seen, within this asset class there are also high risk investments that may lack liquidity. Be careful.
Cash equivalents are useful for maintaining emergency funds.
Cash is a good investment for any short-term personal objectives (e.g., vehicles, housing, weddings).
Cash is also needed to cover short-term obligations in full, or as part of periodic payments (e.g., loan repayments with interest).
As short-term objectives and obligations approach, you can shift assets from less liquid and more volatile investments into liquid and stable cash assets. Do not wait too long to shift to cash. Otherwise, you may receive less than optimal value on disposition due to the asset’s liquidity and risk.
Finally, maintaining a portion of capital in liquid assets is useful to take advantage of sudden investment opportunities.
Cash for the Accumulator
Accumulators are typically young people starting out in life. Or individuals who have experienced a disruption in the normal cycle. Those who have been unemployed, out of the work force for personal reasons (e.g., injury, illness, raising a family), or new entrepreneurs.
In this phase of life, cash requirements may be high as individuals often accumulate 3-6 months emergency funds, begin families, and repay relatively high debt loads. All during a phase where income levels are relatively low.
There likely will not be much excess disposable income with which to invest for retirement. After liquidity allocations, what little one has to begin long-term investing probably should not be placed in cash equivalents.
This is because young investors have a long time horizon until retirement. They can prudently accept higher risk in their investments in order to pursue higher returns. Also, Accumulators will have a relatively high percentage of current wealth allocated to cash anyway. Money that is in emergency funds and available for short-term requirements.
As such, it is hard to estimate what young investors should maintain in cash. Many models suggest 5-25% of total assets in cash for investors with greater than 20 years until retirement. The lower end for aggressive investors, the higher end for conservative.
But perhaps you only have $30,000 in assets. Monthly expenses for rent, food, et al., are $2500 and you want to maintain 3 months of expenses in emergency funds. That equates to 25% in cash and does not even factor in any short-term objectives or payments due. Even if you want to be an aggressive investor, you may need a higher cash allocation until you attain a critical mass in your wealth.
For those who are extremely risk averse, 25% in cash might still be too aggressive for their personalities. They might want to have up to 100% of their assets in cash equivalents. Not what I would recommend for most investors developing a long-term investment strategy, but it might be appropriate for those with absolutely no risk tolerance.
As an aside, some investors maintain their emergency funds in investments other than cash equivalents. They accept some risk – potentially reduced liquidity and loss of capital – in order to generate higher potential returns. We are not talking venture capital. More like short term bond funds or even some lower risk equity funds.
Cash for the Consolidator
Typically, consolidators are individuals in the middle of their careers, probably in their mid 30s to late 40s or early 50s.
Income is relatively high and expenses are low. Personal wealth has increased and debt significantly reduced. There is excess cash available for serious investing.
Individuals should still maintain cash in an emergency fund. But given the level of savings already generated, it may not need to be 6 months worth. And, as a percentage of one’s overall allocation, it will probably be small.
In the example above, the person only had wealth of $30,000. So $7500 in emergency funds equalled 25% of total assets. But if the individual now has $300,000 in assets, a mere 5% allocated to cash for emergencies would be $15,000. Double what was put aside in the accumulation phase. If one maintains the same $7500 in reserves, the percentage allocated to cash falls to 2.5%.
As you can see, the percentage of assets allocated to cash must take into account both your potential hard dollar needs as well as your total wealth.
Consolidators may require additional cash for short term objectives. Buying a vacation property, taking a major vacation, paying for the education of children. Or even just generally upgrading one’s lifestyle with a larger home, better vehicle, and new wardrobe.
As this phase of life will see the bulk of one’s investing, it is also a good phase to maintain some free cash reserves to take advantage of opportunities that suddenly arise. Without available cash, an investor will either need to miss out on the investment or have to liquidate other assets to invest. In selling other assets, an investor will pay transaction fees. The investor may incur taxes on capital gains or face losses if forced to sell something prematurely.
Cash for the Spender
Spenders are those at or near retirement age.
Income will be low, but so too should be one’s fixed expenses. By now, people in the spending phase should have accumulated a relatively large amount of capital.
Because accumulated wealth is high, the percentage allocated to cash equivalents may be low. For example, with $2 million in assets, a reserve of 1% would still be $20,000.
But while mandatory expenses may be low, retirees usually want to enjoy life. With increased leisure activities (e.g., vacations, dining, entertainment), discretionary expenses may result in a desire for greater liquidity and ready cash.
While in their 30s, planning retirement needs, many forget about leisure. They factor in fixed costs, but do not include the increased discretionary spending that comes when retirees want to enjoy their free time. Without doing so, retirees may have enough money to live comfortably, but not enough to travel the world or engage in other more expensive pursuits.
Also, with little to no income, many individuals in the spending phase will have substantially less risk tolerance. They will want to allocate higher amounts to cash as protection in case of emergency (e.g., health issues, stock market crashes).
As you can see, your unique personal situation and risk tolerance will dictate what percentage of funds should be allocated to cash equivalents. And, as circumstances change, so too will your asset allocation percent and/or amounts.
In Part 2, we will summarize and look at the key points to focus on for your cash allocation calculation.
by WWM | Feb 27, 2019 | Asset Classes, Risk, Target Asset Allocation
The core asset classes have general risk-return characteristics.
The greater an investment’s risk, the greater the demanded return by investors.
Cash is low risk, low return. Fixed income is riskier and has higher returns than cash. Common shares have the highest risk and expected return of the core asst classes.
But you need to exercise care when selecting investments within a specific asset class. There can be significant fluctuations in risk-return profiles between investment options in each class.
We will look at a few examples today.
Cash and Cash Equivalents
In general, cash equivalents are considered low risk and low return assets. They are known for their safety and liquidity.
But not all cash equivalents fit this profile.
For a U.S. resident investing in short-term U.S. Government Treasury bills, those characteristics hold true.
High Risk Countries
But the Venezuelan bolívar is also cash. For a U.S. resident investing in bolívar during 2018, the hyperinflation in Venezuela made this currency worthless.
Or consider the Argentina peso. In 2001, the government effectively froze bank accounts for a 12 month period. In large part, liquidity and safety disappeared almost overnight. As an added bonus for Argentines, prior to January 2002 the peso was pegged to the U.S. dollar (USD) at a 1:1 ratio. Then one day Argentines awoke to find the conversion rate re-pegged at 1.4:1. Within short order that re-pegging had fallen to about 4 pesos per U.S. dollar.
What did that mean?
If you bought a USD 600 television imported from America, it cost 600 pesos in December 2001. Less than a year later that same purchase cost 2400 pesos.
Be careful of countries that have a high risk of heavy inflation or the potential for intentional currency devaluation.
Even Low Risk Countries
If you think it is simply countries such as Venezuela and Argentina that need watching, check out the 10 year exchange rate changes between the U.S. and Canadian dollars. Or the USD and the Euro. Or other major currencies. There can be some large swings in exchange rates.
For example, I was living in Switzerland when the Euro was introduced. In 2001, the Euro was usually worth between USD 0.80 and 0.90. By late 2004, each Euro was worth USD 1.36. If you were an American and had bought Euros in December 2001 at 0.88, by December 2004 you would have earned a 55% return.
And if you were living in Euroland and had invested in USD between those years, you would have lost a lot of money.
Two highly regarded currencies. Yet not a low risk, low return investment, was it?
When investing internationally, whether to hedge your foreign currency is always a concern. There are pros and cons to hedging (or not). What is preferable for one investor will differ from the next. And there are multiple variables that require consideration before deciding if hedging is right for your portfolio.
Fixed Income
Fixed income securities are generally considered to be higher risk and higher return than cash equivalents. But lower risk and return to common shares.
Yet again, individual fixed income securities can differ from this generality.
Credit Rating
Fitch Ratings classifies the “safest” bonds at AAA. Lowest investment grade bonds are BBB. Bonds in default are rated D.
As you would expect, the higher the bond rating, the lower the risk of the bond not paying interest on its debt and in the repayment of principal. The lower the risk, the lower the interest that is needed to attract investors.
Conversely, the greater the risk that the bond issuer will be unable to pay the interest and principal, the more incentive is required to attract investors. That incentive could involve “sweeteners”, though often it is simply offering higher yields.
For example, consider four bonds, maturing in 18 years, with no sweeteners or provisions. Data as at February 26, 2019.
Government of Canada 5.00% 01-Jun-2037 are rated as AAA. The yield to maturity (YTM) is 2.074%.
Hydra One Inc. 4.89% 13-Mar-2037 are rated as A (High). The YTM is 3.628.
Bell Canada 6.17% 26-Feb-2037 are rated as BBB (High). The YTM is 4.258%.
Shaw Communications Inc. 6.75% 09-Nov-2039 are rated as BBB (Low). The YTM is 4.834.
You can readily see, as the risk of default increases, the yield to maturity required by investors also rises.
Equities
Of the three core asset classes, common shares traditionally have the highest risk and return.
But this may not always be true.
Other Asset Classes May Outperform
We looked at some fixed income yields above. Assuming a hold until maturity, yields between 2% and 4.8%. Relatively safe, but also relatively low return.
What if we compare this to Canadian equities?
On February 27, 2018, the TSX Composite closed at 15,671.15. On February 25, 2019, it closed at 16,057.03. A one year return of only 2.68%. Lower return than many bonds, yet much higher risk.
Of course, one year is a very short time frame. Too short to properly assess higher risk assets. Over the 10 years ended February 25, 2019, the TSX Composite earned investors more commensurate average annual returns of 7.31%.
Never focus on short term performance for higher risk investments.
Differences Within the Class
Of the three core asset classes, there are the most subclasses within common shares.
Mega cap shares will normally have less risk and return than micro or nano cap companies.
Value stocks may be less volatile than growth stocks.
Dividend producing companies may be lower risk than capital appreciation shares.
Foreign companies may have more risk than domestic.
Defensive stocks may be less risky than cyclicals.
Mining companies may be riskier than utilities.
Or, depending on economic conditions, the opposite may be true.
The individual common shares you select will have a different risk-return profile than common shares as a whole.
That is why investors often diversify through multiple subclasses, to spread the risk. Or purchase exchange traded or mutual funds, that usually contain a substantial number of individual investments to diversify risk somewhat.
That is also why some investors try to time the markets. As one subclass begins to outperform, more capital is allocated to that subclass and away from underperforming subclasses. But the ability to time the market is not easy and the transaction costs can be steep. Many investors get the timing wrong and end up costing themselves return.
Okay, that was a few quick examples of how investments within a specific asset class may differ significantly from the general profile for the class as a whole.
There are many other examples possible, but this gives you an idea as to what I am saying.
by WWM | Feb 20, 2019 | Investment Policy Statements, Target Asset Allocation
You have completed your investor profile. That drives your target asset allocation.
Now you must determine acceptable investment options.
What asset classes and sub-classes to include in, or exclude from, your investment universe.
Core Asset Classes
There are three core asset classes: cash, fixed income, equity.
Previously, we have considered each in some detail.
For a review of cash, please read Cash & Cash Equivalents and Money Market Instruments.
For fixed income, please read Bonds, Notes, and Debentures and Preferred Shares.
For equities, Common Share Characteristics may be useful.
Core Asset Subclasses
Within each of the core asset classes, there are a variety of subclasses.
It is important to understand and differentiate between the subclasses. The core classes may have general risk-return characteristics. But within the class itself, these characteristics can change significantly.
For example, shares in Coca-Cola and shares in a small Kazakstan mining company are both equities. But each has extremely different risk-return profiles. Or Venezuelan bonds are much higher risk than US debt of similar term to maturity.
In future, we will look at differing risk within a specific class.
Within the core classes, you should consider:
Countries
Are there countries or regions that you wish to focus on or to completely exclude?
Perhaps you grew up and worked in Brazil. You might have a better understanding of investments in that country and that may give you a competitive advantage.
Perhaps you live in a country which has investment restrictions on another country. For example, many countries currently have sanctions against dealing with Iran and North Korea. Even if you wanted to invest in these places, it might be difficult to do so legally.
Perhaps there are countries that you do not want to invest within due to personal beliefs. During Apartheid, many countries and individual investors excluded South Africa from their investment portfolios and trading.
Industries
The points I made with countries are also applicable to industries.
Perhaps you are a geologist in Western Canada’s natural resource industry. That may give you special insights into investments in the relevant sectors. As opposed to the software engineer in Silicon Valley.
Many individuals believe smoking is evil and refuse to invest in tobacco industry companies. Pacifists may want to exclude companies that operate in the military areas. And so on.
As well, today there are many socially responsible investors. They actively seek out environmentally friendly and/or socially conscious companies in which to invest their capital.
There are many investment funds that cater to socially responsible and green investors.
Nonsystematic Risk Levels
Within an asset class, individual investments may have relatively higher or lower risk than the class itself.
Do you want to include or exclude higher risk investments?
If so, what is your threshold?
Consider fixed income long-term bonds. Most investors only consider investment grade debt. But if you have a lower or higher risk appetite than most investors, you might want to further limit or expand your debt investment options.
Investment Styles
We have looked at a few different investment styles already.
The main one is growth versus value. Very similar is capital gains versus dividend income. Another common style question involves market capitalization – large versus small.
Or domestic versus global. And when investing internationally, do you hedge currencies or not?
You may invest based on ratios, such as price-earnings or price-book. Perhaps you prefer funds over shares. Active management versus passive. To list a few. There are many choices and sub-choices.
Are there styles you like and wish to utilize?
What about styles that make no sense to you?
Perhaps you believe value investing is right for you and that growth strategies are too risky.
Or perhaps you want to focus on nano-cap stocks and have no interest in the mega-cap sector.
You may also see different styles or approaches taken together to arrive at chosen investments. In large part, this is what takes place in Factor Investing. Currently trendy, well-marketed, investment products. Given the hype, we will likely review Factor Investing in the future.
Your investment philosophy, knowledge, and risk tolerance may lead you to include and exclude certain styles.
Taxes
Investment returns are typically taxed in different ways. In many countries, there is one effective tax rate for interest, another for dividends, and a third for capital gains.
Depending on your income and tax situation, you may want to concentrate on one type of investment and ignore another.
If you live in a jurisdiction that allows tax-free or tax-deferred investment accounts, that too should impact your investment strategies and tactics. For example, in Canada, eligible dividends are taxed at lower rates than interest income or capital gains. It may make sense to hold dividend producers outside tax-deferred accounts. Then hold higher taxed investments within a tax-deferred account for better overall portfolio efficiency.
Alternative Asset Classes
Traditionally, investors focus on the three core asset classes.
But obviously there are other asset classes that merit investment consideration. Once we have covered the core classes, we will review non-core investment options.
Inclusion or exclusion in one’s portfolio of alternative asset classes will depend on three key variables: the investor’s unique profile, especially risk tolerance; understanding of the product and its place in the portfolio; comfort and ability to properly trade these alternative assets.
That said, you will often end up with alternative asset classes in your portfolio just by investing in the core asset classes.
For example, a diverse Canadian equity portfolio will include natural resource and other commodity related companies. Real estate is another asset class that will be in a diversified portfolio.
Hopefully that provides some guidance in assessing assets to include in and exclude from your portfolio.
by WWM | Feb 13, 2019 | Investment Policy Statements, Target Asset Allocation
Asset allocation is easy to explain, more difficult to actually construct.
That is because one size does not fit all investors.
Unfortunately, many investment models try to lump investors into boxes as to a target asset allocation.
The “One Size Fits All” Approach
You will often find asset allocation models that recommend determining your asset allocation based on age.
For example, start with 100 and subtract your age. That is the percentage of capital you should invest in equities. The remainder would be invested in fixed income and cash equivalents.
If you are 25, you invest 75% in equities. Over time you would adjust down your percentage in equities. At 45, your allocation will be reduced to 55%. By the time you reach retirement age, the majority of assets will be in lower risk investments that yield a fixed income stream.
The logic is that the younger you are, the longer the investment time frame you enjoy. The longer the time horizon, the greater the investment risk you can endure (increased volatility will average out over the longer number of years). Based on the risk-return relationship, the greater risk should mean the investment will have a higher expected return over time.
Simple. Makes some sense.
You can use this system as a guideline or starting point in your calculations. But unless you want a weak solution, do not use this approach alone. Or any other cookie-cutter system.
If you deal with a financial advisor who employs this method, I suggest you ask some hard questions before signing on.
It is not an approach I would recommend. Not to mention, you still need to allocate your initial 75% amongst a myriad of possible equity sub-asset classes and actual investments. That also requires some expertise and effort.
You will see variations on the age asset allocation model. Some incorporate basic risk questions. Others add in salary or a few other factors. But they tend to be relatively generic and contain 5-7 possible allocations. The recommendation being the allocation where you come closest.
Simple, easy, but not very attuned to your uniqueness.
Investors are Unique Individuals
As I have written before, it is your unique comprehensive investor profile that should drive your asset allocation. Not a generic formula with a limited number of factors.
Yes, age (i.e., time horizon) is a variable.
Who are You?
But you also must factor in your: current financial situation; phase of the life-cycle; investment objectives and constraints; liquidity requirements.
If you do not, success will be extremely difficult.
Imagine that at age 25 you win the lottery or inherit money from a wealthy aunt. $2 million.
Using the 100 less your age method, you would allocate 75% of the money to equities.
But should you put $1.5 million into equities? Maybe, maybe not. It depends on the other variables in your life.
Did you have $5 million before the $2 million was added or did you have no assets but a lot of debt? What are your other sources of income? Do you want to retire tomorrow or continue on the path to company president? Did you just have triplets and three times the expenses you originally anticipated when planning a baby? Do you intend to buy a $1 million home in 6 months? Is your sister challenging the inheritance in court, such that you may need to share the wealth and pay some legal fees? And so on.
These issues all relate to your personal financial situation, both current and desired.
What is Your Risk Tolerance?
With respect to your investment approach, what is your risk tolerance?
Do you take a rational approach to investing? Do you realize that there may be large swings in your portfolio’s market value and that your $2 million may fall in value?
Or are you like many investors, more emotional in nature?
Are you someone that reaches for the antacids every time the S&P 500 dips half a percent? If so, you might prefer to sacrifice some potential returns in exchange for liquidity, stability, and safety of the capital. What good is $2 million if it erodes to $500,000 due to volatility in the markets or bad investment choices?
Or, are you on the other extreme? Equities? No way! That money is going straight into an options and futures trading accounts. It was found money and you will leverage it to the hilt. Then buy your own island in the Caribbean and proclaim yourself ruler! If you lose it all, well it makes for a fun story at the pub with friends (or in the welfare line).
Do you like the safety of government backed securities? Or do you want to trade options? Or are you somewhere in the middle?
How you perceive risk will greatly impact your asset allocation.
Determining Your Personal Asset Allocation
Understand Your Financial Situation
Knowing where you are today, and where you want to go, is important in determining asset allocations.
Your current financial situation is simply a snapshot of your life at one moment in time. As you get older and move through the life-cycle, your wealth, objectives, constraints, and risk tolerance, will undoubtably shift. Always be prepared to revise your investor profile as needed.
Subsequently, as your investor profile shifts, so too should your target asset allocation.
Also, be realistic in your objectives and constraints.
If the stock market has averaged returns of 8% per annum over the last 10 years, it might be unrealistic to assume you will earn 25% annually on your portfolio. Or if you just graduated from university, it might not be best to plan on being President of a Fortune 500 company by the time you are 30.
Both could happen, but I suggest that you take a conservative approach to your plans. Underestimate your objectives and overestimate your constraints. That may save a lot of disappointment later.
Develop a comprehensive plan of action and work toward your goals. It is surprising what is attainable if you put your mind to something. But for financial planning purposes, factor in a margin of error in your assumptions and targets. It is better to worry about dealing with excess wealth than to in arrears when you wish to retire.