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A simple way to arrive at the right asset allocation for your portfolio

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What’s your piece of the pie? 

 

Instant asset allocation

Asset allocation can be as complicated as you want to make it. But since many investors don’t have time to get overly complex about assets in their portfolios, here’s a simple look at how to allocate.

Financial planners used to say subtract your age from 100:

  • The remaining percentage is what you should have in stocks

So, if you’re 30, keep 70 per cent of your portfolio in stocks. If you’re 70, keep 30 per cent in stocks.

The best asset allocation for your age

Canadians can look forward to living longer. Because we’re living longer, we have to take this into consideration when it comes to our portfolios. Some recommendations are suggesting the number used should be increased to 110 or 120 minus your age reflecting our greater longevity.

If you’re living longer, you need to make your money last longer. You’ll need the extra growth that stocks can deliver.

Many experienced investors find that adjusting the number to suit their risk tolerance after a large correction, say, like 2008-2009, a good metric. Large corrections can get you in touch with your investor psyche pretty quickly. But be cautious about selling when the mood has reached maximum pessimism. It rarely turns out well.

In “Plan like a pension fund manager when it comes to your investment portfolio”, I discussed the benchmark for the average diversified fund manager. The important thing is to choose an asset allocation you think you can be comfortable with.

For example, if you had a 50/50 portfolio split, you could expect that your stock holdings would move a lot less than a broad index like the S&P/TSX 60 in Canada, or the S&P 500 in the U.S. While you may be tempted to think it’ll move half of one of these indices, it will depend on how close the equity component of your portfolio correlates to either of these indices. If your stock allocation is geographically diversified, this will also change things.

When you compare the S&P/TSX 60 (60 of the biggest companies in Canada) with a balanced fund that is geographically diversified, we’d expect, generally, to see:

  • Less volatility because of the fixed income component in the balanced fund
  • Less volatility because of the geographic diversification in stocks and bonds in the balanced fund

This is exactly what happens when you graph the S&P/TSX 60 and the Claymore Balanced Growth Core Portfolio (TSX:CBN). The Claymore portfolio is based on the Sabrient Global Balanced Growth Index. Roughly an 80/20 balance between growth and income-oriented ETFs holding stocks and bonds.

Diversification reduces volatility

The S&P/TSX 60 shows more volatility than the Claymore ETF. There are reasons for this.

The S&P/TSX 60 is made up of sixty of the biggest stocks in Canada – one country with a big presence in financials, energy and materials.

The Claymore ETF is geographically diversified. It holds stocks from all over the world. It also has a fixed income component. Its equity and fixed income allocations are further diversified. They hold different investments that perform somewhat differently depending on market/economic conditions.

What investors have to remember is that while volatility is reduced when fixed income products are added to a portfolio, it also reduces the upside of the portfolio when markets turn around. A geographically diversified portfolio with fixed income products added into the mix isn’t going to perform as aggressively as the broader stock market.

Most investors can tolerate less upside for less downside. As we’ve recently seen, it’s the drops that make people a little shaky in the knees.

Remember, should you want even less exposure to stock, there are plenty of products out there that are closer to a 60/40 split between equities and fixed income.

Asset allocation is going to affect performance and risk. You can always use systems (like the simple ones above) to come up with a benchmark for your portfolio, but in the end, your portfolio’s going to be slightly different because it won’t have exactly the same investments.

Opportunity abounds in down markets. Part of the opportunity of market volatility is figuring out your risk tolerance. If this last correction gave you palpitations, maybe you have too much stock.

But consider:

  • The markets have corrected. This graph is from September 2010 to September 2011. If you sell investments now, you may be selling near the bottom.
  • Having an asset allocation system in place is going to be the best benchmark for rebalancing your portfolio. If you haven’t had such a system in place, think, and act now.

There may be opportunity out there. In fact, the last few days in the markets have seen some extraordinary upward movements in equities. September is often the cruelest month in markets, but October has ended a lot of bear markets historically. Bad news travels fast and furious, yet the sounds of optimism often appear within the pessimism and noise.

*ETFs used here are for illustrative purposes

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4 Responses

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  1. Thanks for demystifiying a pretty complex subject.

    D Hemmings

    November 4, 2011 at 1:28 pm

  2. Really great post. Enjoyed reading!

    Jane M P

    November 4, 2011 at 4:56 pm


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