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 the Cash and Cash Equivalents core asset class? Besides potential diversification, why invest in very low-return CCE? How does your life-cycle phase impact cash investments? What about personal circumstances and cash flow needs? Does one’s risk tolerance impact cash holdings?
“What is Cash and Cash Equivalents (CCE)? Why is it a core asset class?”
CCE covers liquid assets, usually with maturities under one year. Liquid, safe, low volatility, but also with very low investment returns.
It is considered a core asset class, due to the importance of maintaining some liquidity. CCE is very useful for emergency reserves. As well as short-term financial objectives, cash outflow requirements, and to have on hand for investment opportunities that arise.
“What are the CCE considerations for those in the Accumulation life cycle phase?”
Accumulators tend to be relatively young, just starting their careers. With little wealth or CCE on hand.
While CCE provides little return, there are reasons why Accumulators need CCE in their portfolio. Compared to the other life phases, in relatively higher percentages of the asset allocation.
“What are the CCE considerations for those in the Consolidation phase of life?”
Consolidators are typically older, in the prime of their careers and earnings. They have some wealth accumulated and cash inflows should cover recurring outflows. Consolidator cash requirements are much different than for an Accumulator.
However, CCE still is important. In meeting short-term financial objectives, such as buying a new home or paying for a child’s education. Also, in this phase of life there are often investment opportunities. It is useful to have liquidity on hand to take advantage.
“What are CCE considerations for those in their Spending phase of life?”
CCE issues for Spenders also differ from Accumulators and Consolidators.
Spenders are close to retirement and want to enjoy life. They probably have wealth accumulated, but may no longer have employment income to increase their capital. They may wish to increase their stability and portfolio liquidity, including increasing cash balances.
While some costs are no longer an issue in retirement, such as mortgage payments, other new expenses may emerge. Health care, world travel, helping finance children and grandchildren. Again, having that certainty of CCE investments is often desirable for Spenders.
“How can personal circumstances impact CCE allocations?”
Many personal issues fall under a life cycle phase. But some may be common across many phases of life.
Regardless of age, people often have short-term planned expenditures. For an Accumulator, getting married, having a baby, buying that first home. For a Consolidator, maybe a lake house or rental property. Sending a child to college. For Spenders, a trip to Europe.
There are also the unplanned costs. Job loss, vehicles that need replacing, health issues. Part of the emergency reserves is held to cover these unforeseen expenditures.
Tied in to unplanned costs can be the type of job you hold, where you live, etc. If you work in a cyclical sector, such as oil and gas, maybe you have strong employment in boom times. However, if the oil industry suffers, you may be prone to unemployment. If you live in the Caribbean, maybe you run the risk of hurricanes. That can also impact employment or repair costs.
“How does one’s risk tolerance impact the CCE allocation?”
Some people have a high risk tolerance. They will want the bare minimum in CCE, due to its low returns. If there is an actual problem, they will figure it out then. For now, not a consideration.
Others may want to have more than might be necessary in CCE. They sleep better knowing all possible problems can be covered.
Where you are in your life phase, your personal circumstances, and personal risk tolerance, can all impact the amount you allocate to CCE. There is no “one size fits all” for CCE. Consider your unique situation and allocate based on that.
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.
When trying to find a financial planner or advisor, it is important to assess advisor compensation. How is the financial advisor paid? In sales commissions and ongoing mutual fund retrocessions or trailer fees? Salary and bonus from an employer, such as a bank or insurance company? Percent of Assets Under Management (AUM)? Or in fees paid directly by the client for services rendered? Often in a fiduciary capacity.
“My financial advisor provides me with free advice. That must be a good deal, right?”
Possibly. But there tends to be no such thing as a free lunch. There are pros and cons to the free advice business model. The biggest negative tends to be that you end up paying a sales commission on products purchased. As well as ongoing fees embedded in the mutual fund or investment.
“What is this about if I prefer a front, back, or declining load when I purchase this fund?”
That would be the sales commission when you buy a no-load (no commission) product. They can come in many shapes and sizes. Usually with more than one option for a specific investment product.
Which you choose, if any, is usually based on your personal financial situation.
“I have heard the term, ‘retrocession’. What does this mean to me?”
Retrocession and trailer fees also come in different forms. Usually where an investment or fund company pays an ongoing fee to the advisor who sold you the product.
For example, if I sell you a mutual fund, maybe the fund company pays me an annual fee as long as my client owns that mutual fund. Perhaps 0.50% per year of client assets in that fund. That is in addition to any sales commission when you initially purchase (or go to sell) an investment product.
Obviously, some potential issues and conflicts of interest in this area. Is the advisor putting you in the “best” investment product for your needs? Or is the advisor putting you in a fund with the highest fees?
“What is a percent asset under management fee (AUM) model?”
As it suggests, clients pay an annual fee based on the amount of assets held by the advisor. Normally, the greater the assets, the lower the percentage charged. Of course, 1% on $5 million brings the advisor much more in fees than 1.25% on $1 million.
There are also various advantages and disadvantages in this fee model. The big plus is that the fees are transparent. If you pay 1.0% on your $2 million, that is $20,000 per year.
Also, you can often negotiate your fees.
On the downside, you often require a certain asset size to qualify for these models. If you have $250,000 in bankable assets, this may not be an option for you. Also, service quality may differ between those of different asset values. Not in attention given to you by your advisor. But often the more assets you have, the wider the included service offering for the fee.
“My advisor offers a fee-only business model? How does this compare with the others?”
A good question. In a “free” advice model, you often pay a sales commission when you initially purchase (or sell) the investment product. You also pay an ongoing fee to the advisor that is embedded in the fund’s management expense ratio.
In a percent AUM model, you pay an annual fee based on the amount of assets held by the advisor. You may, or may not, pay additional fees for products and services.
In a fee-only model, the advisor directly charges the client for the professional services. Much more like working with your lawyer, tax accountant, dentist, fitness coach, etc. You pay for expertise and that is what you get. There is no incentive for the advisor to push any products, because there is no fee received. In either sales commissions or ongoing trailer/retrocession fees.
That is the big advantage of this model. You get unbiased, independent advise. Often, fee-only advisors act in a fiduciary capacity. Not something you experience with percent AUM nor commission advisors.
There tends to be three potential downsides to fee-only advisors. An up-front fee, potential for padding hours, and the quality of the advisor.
Fee-only advisors charge based on work performed. Clients with less assets may have simpler needs, so less time. But there are still the basics that must be performed regardless of asset size. If you have $100,000 in assets and the advisor wants to charge $7500, that may not be a great match for you.
Not paying anything up front, but incurring an annual fee embedded in a mutual fund, might make more sense at this stage of life. Of course, within a few years, the fees you pay the fund will be much higher in cumulation.
As for padding the invoice, fee-only advisors are paid on an hourly basis. That may be an incentive to add an hour here or there to the file. Or a worry with a client that the advisor is always “on the clock”. That may discourage asking questions or raising issues that arise. A legitimate concern.
In my practice, I usually try to estimate the work necessary up front. Then offer a flat fee for the specified services. If I require additional time and/or issues arise that are outside of the agreed upon scope of work, I discuss with the client before starting. That maintains transparency and manages expectations on costs of the engagement.
Finally, if you are paying directly for an advisor’s expertise, you want someone with strong technical skills and experience. But that is usually true regardless of the advisor model.
“Okay, commissions versus %AUM versus fee-only. Which should I choose?”
Often it depends on the personal situation. If you have $100,000 in assets, you may not be able to even find a percent AUM advisor. And you might find the price of a fee-only advisor does not make sense. That may leave only the commission model or figuring it out on your own.
If you have $50 million, then you may actually want the AUM model. As you can pay a relatively low fee schedule. And, with that level of wealth, receive a high level of personalized service. Or, you could hire in-house expertise. Instead of paying a fee-only advisor $500 per hour, you could hire that person full-time in a Family Office arrangement.
That said, the video looks are a variety of cost scenarios for some idea on what my be best for your own financial situation.
It is always interesting to calculate how fees impact compound returns and wealth accumulation over time. Well worth seeing how your fees create lots of wealth for others, much less so for you.