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

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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Part Two — Get the balance right

Can we simplify asset allocation?

Yes, we can.

Watch out for rebalancing fever

It’s possible to get rebalancing fever. Be careful. Like all manias, there are dangers. If you start rebalancing your portfolio every time there’s a slight move, you may find you have no more time for anything else – not to mention creating potential tax liabilities.

In “Let’s think about assets” I also discussed rebalancing. A five per cent portfolio drift is a good measure of when you need to act. The time frame for a five per cent change in your stock or bond allocation depends on markets and economic conditions, investor sentiment and the ever-changing universe of moving parts and multiple players in a global economy. It’s a fluid investing universe.

Automatic for the people

The key with asset allocation is to make it automatic. The sun will rise. The sun will set. Investors rebalance their portfolios.

Eliminating emotion from your rebalancing philosophy makes it more effective. When you rid yourself of the “noise”, you can gain focus, discipline and the ability to implement.

Check your portfolio at least once a year. If you do, you should be able to catch when your portfolio needs rebalancing. When your allocation has strayed enough, rebalance. During times of great volatility, like this past August, have a peek to see if your allocation has moved enough.

Do your emotions get the best of you? Stick to looking at the percentages of your different allocations rather than the dollar values of investments. Market corrections and severe volatility have a way of making investors, especially novice investors, weak in the knees.

Discipline

There is one overarching rule to rebalancing:

•             Stick with your plan

Once you have decided on a plan of action, abandoning your strategy makes it useless. So why do so many investors flee their plans when the going gets tough? Because they’re allowing emotion to eat into their strategy. Often, the cause is assessing yourself as a more aggressive investor than you really are.

Everyone is superhuman when there’s no kryptonite around.

What’s an investor to do?

Use market corrections to re-evaluate your risk tolerance. Corrections are opportunities. Not only do they show who you really are as an investor, but they reveal inevitable bargains.

Remember, assessing yourself openly and honestly as an investor is very important. After all, this is a conversation with yourself (and your advisor, if you use one).

In the end, every investor has to take a certain amount of responsibility for their investment decisions. We should expect good counsel, transparency and best practices, but we are the best evaluators of ourselves – especially during market volatility. The financial crisis and the resulting market drop clearly demonstrated that many investors couldn’t take the heat. That’s okay.

Know thyself. Then move forward from there.

When it all comes down to it, remember, if you’ve been sitting in GICs for the last few years, you have missed out. (See “Bonds: Why you should love the unloved investment”)

Invest in You Inc.

The thing some investors miss when they rebalance their portfolios is that rebalancing really is taking stock of you. When the media becomes shrill and volatility is very high, this is a strong signal to look in the investment mirror and ask:

•             Who am I?

•             What’s going on?

•             Where are the opportunities?

All we are is all we are

No one ever knows exactly what the markets are going to do. Rarely are great opportunities uncovered by knee-jerk reactions to our most basic fears. We are who we are. But we can all step back from ourselves, think, and reflect:

Fear is a great motivator, but so is stepping outside of fear and looking out at opportunity. Opportunity is like a good neighbour. Often, the potential for good fortune knocks at the door in an unusual form. It’s up to us to recognize it.

Meanwhile, there may be shrill voices on the street and much gnashing of teeth.

Part One is here.

Find out more: Asset Allocation can be easy as A, B, C

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Part Two — Bonds: Why you should love the unloved investment

Count bonds. Forget about sheep.

5-year chart comparing Canadian government bonds and the S&P/TSX 60

In the two years before the financial crisis, government bonds underperformed. Stock markets were hitting all-time highs and few investors were interested in bonds. However, as the risk premium for stocks was rising and stock indices in Canada and the U.S. were hitting highs, shrewd investors were reallocating their portfolios to include more bonds.

Bonds were unloved, but they were cheap, and when stock markets came down in a hurry, bonds acted like the buffers they are: they rose while stocks were coming down in portfolios.

The case for bonds in a portfolio as a permanent asset seems pretty solid. Let’s take a look at the last six months.

6-month chart comparing Canadian government bonds and the S&P TSX 60

Over the last six months, stocks have finally gone into a correction. Stocks have been incredibly buoyant since the bottom of the 2009 crisis and have performed very well. But corrections are a normal part of the investing landscape. Corrections are healthy since they clean out the speculative element in the market periodically. Investors, on the other hand, especially average investors, aren’t huge fans of volatility.

Looking at the chart over the last six months, we can see that government bonds turned up as the markets headed down. Bonds are doing what they do, once again: smoothing out returns by acting like insurance in your portfolio.

Equities hit home runs, but bonds keep you from crashing into the catcher’s mitt and getting called out at the plate.

Equities should outperform bonds in the next few years because bonds have made out well recently, but good diversification together with prudent asset allocation suggest the average investor should have some bonds in the asset mix. Recent news has shown us how commodities and stock markets can change direction in a hurry.

The debt situations in Europe and the U.S. illustrate the importance of having Canadian bonds in a diversified portfolio. Canadian bonds are in a good place when it comes to quality these days.  Just when many were saying Canadian bond returns had peaked and there was no future investing in them, boom, sovereign debt issues exploded in the media – again. Both recent history and the last few days are excellent reminders of why bonds have a place in the average investor’s portfolio.

Canadian government bonds may not work in a get-rich-quick scheme, yet when it comes to your portfolio, it pays to think. Think of bonds as insurance. Think of bonds before you go to sleep. In times of volatility, count bonds and forget about the sheep.

Part One is here.

Update: Foreign investors are also loving the unloved investment in Canada.

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Bonds: Why you should love the unloved investment

Over the last couple of years bonds have been unloved. Interest rates have bottomed. Equities are historically cheap. The economy’s getting better.

Why debate any of the above? Surely, there’s some truth to these statements, and if you pay any attention to the financial news, you’ve heard them all.

Despite the lack of love for bonds, here are some reasons to hold bonds close to your heart through thick and thin, but especially through thin.

In 2009, when it seemed the earth had opened up and was swallowing investors and their portfolios whole, what did bonds do? They did what they’re supposed to do. Bonds acted like investment insurance. Bonds digested the increasingly bad news and turned that news into concrete returns. Interest rates plunged as governments moved to respond to economic fears, some rational, others less so.

Bonds or GICs?

How did bonds do vs. GICs?

The chart compares the Dex All Government Bond Index with 1-year GICs. Over three years, the bond index outperformed GICs by about 14 per cent. That’s roughly seven times the return. If you were invested in an ETF or a mutual fund holding Canadian government bonds, you would have made out well. And your investment would have been more liquid since GICs generally tie-up your money for the period you’ve agreed to invest for.

Stocks or bonds?

Bonds vs. equities

Over four years, if we compare bonds and stocks using the Dex Bond Index and the S&P TSX 60 Total Return Index, which includes dividends, we see that bonds outperformed. Of course, considering that the correction of 2009 was one of the deepest since the depression era, this isn’t much of a surprise. Bonds returned about 22 per cent while the S&P TSX 60 returned about three per cent over that period. It was an excellent period of outperformance for bonds.

The last few years, the financial media has been full of stories about why bonds won’t be the best of investments in the future. True. Bond prices are historically high at the moment, but every story should include that bonds tend to insure a portfolio – and they should always be part of a proper portfolio. Because they outperform, as demonstrated by the charts, when the stock market gets beaten down (see the financial crisis of 2009), bonds should always have their place in your portfolio.

No bonds? Your tolerance for risk had better be high. Bonds outperform when times are tough, and as bond assets rise they take some of the edge off the equities that are falling in your portfolio.

Why does this bond outperformance happen? Because during tough times, investors put their money in high quality investments like government bonds. Governments also tend to lower interest rates during times of financial turmoil. When interest rates go down, bonds become more valuable because the rates of interest they pay are more valuable when compared to new issues carrying lower interest rates. And that’s exactly what happened over the last four years. Bonds went from underperforming equities to outperforming them as jittery investors jumped into the asset class, and governments lowered interest rates in order to provide liquidity during the crisis.

Want to see a great infographic about bonds? (Somewhat U.S.-centric but still educational.)

Stay tuned for Part Two.

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Infographic: mint.com

Bad news, gold and dividends: When it’s pouring through the roof – what’s pouring into your portfolio?

In “Gold Riot”, I wrote about gold , discussing how it might be overvalued. My post was a little early.

We recently saw a couple of interesting days in the gold market while silver corrected heavily. It’s rarely a good time to take a position in a commodity after an enormous run up. After all, when investments get sold off, there are some powerful players out there, and they can cause some big price movements. For example, Goldman Sachs.

Some investors are now taking positions at better prices, still, the behaviour of gold and other metals has melted some hearts. Newbie investors heavy on silver must have had some palpitations during the spectacular volatility.

With everyone talking about gold, and with it seemingly pouring bad economic news at the moment, how do dividend stocks fit into the picture?

My focus is more on average investors than speculators, and the average investor generally has less of a stomach for volatility. Many investors aren’t even aware there’s quite a difference between gold stocks and gold bullion and how they both perform. There’s a lot more volatility in gold stocks, and gold stocks’ performance is based on the outlook of the underlying companies. (For more on this, see the above link “Gold Riot”.)

While silver was making the headlines for all the wrong reasons, dividend-paying stocks have outperformed. “Get paid to wait” is the mantra of investors in dividend-payers. During difficult periods of volatility, those dividends are smoothing out some of the volatility in price movements. When comparing the iShares Dow Jones Canadian Select Dividend Index to gold as a commodity, gold still did pretty well if you bought early, however, many bought very late — rarely a good thing. It would have been better to wait for a correction.

iShares Dow Jones Canadian Select Dividend Index Fund, S&P TSX Global Gold Index and XIU (nearly a proxy for the S&P TSX 60)

Many investors don’t have the time or don’t want to spend the time glued to the markets. While nothing is ever guaranteed with any investment, dividend-paying stocks will give you a little more comfort. The highs may not be as high, but the lows are also not quite as low.

When news is uniformly bad, remember that stream of dividend payments pouring into your portfolio. The managements’ of dividend-paying companies believe enough in their businesses to share some of the wealth with you.

So how did these asset classes make out? Dividend-paying stocks returned more than 10 per cent while gold stocks were down 15 per cent over the last year. Gold stocks have disconnected from bullion for now as regards performance. It happens.

Bullion had a good return at about 18 per cent but with a lot more volatility than dividend-payers. Gold stocks are potentially even more volatile. My target audience is more the average investor, so I won’t over complicate this — gold bullion has had a lot of its recent increase because of bad economic news — this is a bit of a simplification. More is involved in the price of gold, but does the average investor need complication? What is important is that if the news outlook changes, so might the performance of gold.

Remember, if you own a broad-based Canadian equity fund, it probably has somewhere between 15 – 20 per cent of its holdings in gold or other mining stocks. How much gold do you want?

Better yet, how much gold does a proper weighting allow for? If you’re not a speculator, keep your gold holdings manageable at 5 – 10 per cent of your total portfolio. A good fund manager has a lot of intelligence when making decisions on gold stocks. Do you? If you’ve decided to hold a significant weighting in gold stocks or bullion, you have become a speculator. Do you have time to watch your holdings with the eye of a fund manager or a speculator? Probably not.

An investor holds shares in a business and shares in business ownership. The average investor would do better thinking like a business owner rather than a speculator.

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Goliath gets a dose of realism: Does the average investor understand how Nasdaq’s re-evaluation of Apple’s weighting could affect markets?

Nasdaq had to reshuffle. It hadn’t touched weightings since 1998. Nasdaq decided it’s not in investors’ interests to have one holding representing over 20 per cent of the index. And it’s right, such an over-weighting doesn’t represent an investors’  best interests.

It’s been said before, and it’ll be said again, one company’s over-weighting in an index counters the principles of proper asset diversification. Think Nortel and what happened when it was hugely dominant in the Canadian stock market. When Nortel got crushed in the tech bubble so did Canadian investors — many  watched their portfolios bomb.

Investors have definitely benefited from Apple’s meteoric rise over the last few years, however, at some point, rational thinking has to prevail. Do you really want the extra risk associated with an enormous weighting?

How many investors buying the Nasdaq know how overweight Apple is? In slashing Apple’s weighting about 8 per cent down from 20 per cent, Nasdaq’s doing the responsible thing.

Apple has been getting an enormously disproportionate share of the market due to its dominance of the Nasdaq. Apple’s been profitable but so have other companies.  In comparison, Microsoft, posting profitable quarter after profitable quarter, hasn’t been getting its due. And it pays a dividend!

Perception often rules over reality in the markets. But reality often comes back with a smack.

In the short-term, there will definitely be re-weightings of Nasdaq stocks in portfolios the world over. These re-weightings should benefit Microsoft, Cisco, Oracle and Intel. Apple stock should experience some interim pressure as managers adjust their portfolios over the next month.

What the future holds is as yet unwritten, yet Nasdaq’s re-weighting of the benchmark will be a wise long-term move for the index.

While the Nasdaq is nowhere near the valuations of the tech bubble, Apple has done almost nothing but go up since the financial crisis. However, during the volatility of the crisis, it got hammered.

Portfolio managers are measured against the indices that are their benchmarks. A benchmark should never be overweight one stock. It forces managers who want to compete with the index to buy more of the very stock they should be cautious about.

Here’s a graph and story of what happened to the Nasdaq after the tech bubble, when mania overcame rational, strategic thinking.

Gold riot

Warren Buffett’s thoughts on gold or how looking at the return on gold might reduce the glitter

The riot over gold has calmed down a little, however, there is still significant interest in the metal. An interesting perspective on gold comes by way of value investor par excellence, Warren Buffet.

Will all the gold that glitters glitter less?

There is no denying gold has had a great run. What people forget when gold performs spectacularly is that it has often caused investors an enormous amount of pain as well. Gold is volatile. It soars, but it has also come down very hard throughout its history – part of the reason that most recommendations limit gold to about 5 per cent of a portfolio (in order to smooth out volatility).

Gold has performed very well this year and over the last few. The S&P/TSX Global Gold Index has doubled the S&P/TSX 60 this year. But gold’s performance comes with a lot more volatility. The fact that gold is such a big sector within the Canadian stock market has been advantageous this year. Gold often kept the Canadian market buoyant when other stocks turned downward. It acted as kind of a built in hedge. However, should gold turn south in a significant way, it will also hold the Canadian market back because of its large weighting. In fact, by just holding an index fund or ETF tracking the S&P/TSX 60, you have about 20 per cent exposure to the materials sector, and, a large portion of that is in gold. The broad Canadian market has a lot of gold exposure already.

Unfortunately, gold is on everyone’s tongue lately.

But what does Buffett say about gold?

Gold just sits there

Buffet has become wealthy by being a value investor. He believes in goods and services and buying the undervalued companies that deal in them.

If you don’t listen to Warren Buffett at some level, you’re odd. Whether pundits agree with him or not, his opinion is focused on and respected. Buffett says there is no place for gold in his portfolio – intriguing, because, unlike Canadian investors who have seen appreciation in their currency, Americans have been dealing with a declining dollar, resulting in the rush to gold as a hedge against devaluation. Throw in the troubles in the world economy, the devaluation of the Euro, etcetera, etcetera, and the rush to gold isn’t exactly surprising.

Buffett’s logic on the metal is definitely interesting. He thinks gold is useless.

That’s right. Useless.

Buffet on gold:

“(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

Ah, the Ziggy Stardust gold analysis …

In Fortune, Buffett recently said:

“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States,” Buffett said. “Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

A very, very interesting illustration …

Buffett has stayed consistent with his messaging on gold.

• Expensive to store
• Has no practical use
• Doesn’t generate income

Of course, some of the large players that mine gold do generate income, but Buffet’s talking more about buying the metal itself.

The S&P/TSX Gold Index has done very well in the last ten years. It has returned about four times the S&P/TSX 60. However, during the dog days of the financial crisis, it collapsed along with everything else, and that collapse wiped out all gains since about 2002. Gold has recovered spectacularly since then though not without some equally spectacular volatility. Without a doubt, placing a big bet on gold increases risk immensely. If you’re looking to steer away from volatility, putting more than 5% of your portfolio into gold could leave you with a nasty surprise.

Gold stocks, because of their leveraged positions with respect to gold perform even better than the metal, generally, yet that outperformance goes the other way in a hurry at times. So, gold stocks can be a great hedge, but they also have some explosive volatility built into them – volatility which can go either way faster than most people can monitor.

The big question is which way will gold go in the near future? And, how much has the risk premium for holding gold increased?

For Canadian investors, this question doesn’t hinge on a declining currency. Our market has a huge piece of gold already. If you own the broad market, you’re already exposed to gold. That can be a good thing or a bad thing. In the last ten years, it’s been a great thing, but all good things come to an end. Are we closer to the end of gold’s aggressive increases or is there still room to shine?

For the average Canadian investor, if you just own the broad market you have exposure to gold and its advantages. At the same time, should gold have a significant correction, you’ll feel it.

Buffett’s comments on holding gold bullion (even though it’s easier to do with ETFs now) bear some thought. Expensive to store. No practical use. No income.

Looking for value makes one a big fan of dividend-paying investments. Canadians already have exposure to gold. Would you take a flyer on gold at these prices? Such an idea may have lost its sheen.

If you are a trader, that’s one thing, but if you are an investor, polishing gold may leave less of a glimmer lately.

Now, if there were a significant correction in gold, that would change things, but right now gold looks like its bumping its head on a ceiling. Whether that will be temporary or longer lasting depends on many different interconnected moving parts within the economy.

The questions it’s prudent to ask yourself with every investment are:

• Am I likely to get the same return on my investment next year?
• Will I get even half of that return?
• Am I using sensible portfolio approaches regarding the construction of my investment portfolio?

A portfolio of gold stocks I was looking at recently has returned over 70 per cent year-over-year. The broad market has returned less than a third of that. Over 50 per cent of that return has come in the last six months. Recently, this portfolio has pulled back 6 per cent – and it is a broad portfolio that has increased over 800 per cent over the last ten years.

Is it cheap? Does a correction of 6 per cent add much value? …

Not exactly a huge pullback.

Every Canadian investor who holds the broad market holds gold. Loading up on gold may not be the best of all portfolio moves. At this point in time, Canadian investors find themselves in a different situation compared to their American counterparts.

The gold rush may not be over but there certainly are a lot of people panning in the stream.

 

For an update on gold stocks, gold bullion and dividend-paying stocks click here.

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Asset allocation: Diversification is king

The king and you

Invest in different asset classes, across geographies, sectors and styles, and the impact of any one investment on your portfolio is diminished. Most investors, especially new investors, worry about poor performance but forget about the importance of diversification.

For example, if your only investment is your house, then you’re not very diversified. Ask anyone who was overloaded in U.S. residential real estate about how lack of diversification can negatively affect your portfolio.

These days diversifying is easier than ever. You can invest in real estate, international stock and bond markets, emerging markets and commodities. You don’t have to simply depend on domestic stock and bond markets as much as investors once did.

But what is important is considering the risk/reward features of these asset classes. You don’t want to invest too little or too much in any one asset.

The challenge of asset selection

The number of investments available today is truly staggering. Individual stocks and bonds, mutual funds, ETFs and managed accounts are only a few of the types of investment options. If you want to manage risk well, you have to evaluate how each investment will impact your portfolio.

Benchmark indices help financial professionals gauge the performance of their assets under management. Some investments are designed to very nearly track these indices. Many exchange-traded funds seek to offer investors nearly the same performance as indices.

Individual securities or actively managed funds hold out the potential to outperform the indices they are based on. However, these investments rarely do outperform. And they often carry higher risk and higher management fees that are a detriment to an investor’s overall portfolio depending on the extent of an investors understanding of markets, and the level of advice she may need.

Determining the level of risk you are comfortable with is crucial. Mixing index and active investments into your portfolio will benefit you when it comes to the end result of achieving your objectives.

Rebalancing

Rebalancing your investments is key. Periodically, investors should review their portfolios and re-assess their investments and long-term goals. Often, this requires selling your best-performing investments along with the discipline to execute your plan.

“Buy low and sell high” may be the mantra investors want to follow, but for many, it’s easier said than done. Risk management best practices suggest that an investor must pay just as much attention to selling high as buying low. Getting overly greedy after a good run in the markets is dangerous to your portfolio.

By rebalancing, you can stay on track. Proper asset allocation helps you stick to your risk/return objectives. Although this sounds easy on paper, it’s not. Systematizing the rebalancing process is one of the most important processes of a sound investment plan.

How to be a smarter investor

Most people obsess about investment performance. While tracking the performance of your investments is without a doubt important, are you considering risk?

Investors generally understand risk. For example, not meeting investment goals stands out as a hazard when it comes to portfolios. But without risk, there is no return. You have to take some risk to earn better-than-average returns.

So, how should you consider risk? How does risk fit into your portfolio? If risk and reward are so heavily correlated, how much should you be taking? How can you manage risk properly?

Understand risk

What is risk, anyway?

You can’t control everything. The recent market meltdown was out of investors’ control. But how you organize your portfolio is within your control. And that’s empowering.

Most Americans investing in residential real estate didn’t think they were taking on a lot of risk. Yet U.S. residential real estate dropped by about 50 per cent from its peak. You definitely increase your risk with all your eggs in one basket. But you can manage risk. You can create less uncertainty and the stronger probability of meeting your investment goals.

Are you taking on too much risk? Is there overlap in the securities or funds you hold? You think you’re well-diversified, but are you really? On the other hand, if you’ve been holding only low-risk, low-return investments like GICs over the last ten years, you might feel sorry. Why? Because if you held a basket of Canadian financials (even with two major stock market corrections), you would still come out ahead. Yes, risk offers the potential for higher returns. However, you need to determine what the appropriate amount of risk in your portfolio is.

In order to create an intelligent investment plan, you need to evaluate your risk tolerance. You need to ask yourself questions like … How much risk are you willing to take? Is a very conservative strategy going to allow you to achieve your investment goals? Research shows that being too conservative also entails risk when it comes to achieving portfolio goals. Risk is not only about aggressive investments. Conservative investments carry risk, too.

Risk, by any other name, is still risk

Risk can take many shapes and forms. Do you have the right investments? Are you being too aggressive? Or maybe you’re not being aggressive enough? The best way to consider risk is by having a sound investment plan.

Considerations for your investment plan

• Asset allocation

• Choosing assets that will make up your allocation

• Rebalancing your portfolio

In an upcoming post, I will discuss the above fundamentals.

What the heck is a TFSA, anyway?

It never surprises me when I hear someone say they don’t really understand certain investment or savings vehicles. After all, there are a couple of them out there. So, what is a TFSA, and what are its advantages to you?

A Tax-Free Savings Account (TFSA) is a flexible savings vehicle. It is a general purpose vehicle allowing Canadians to earn tax-free investment income. That’s right. I said “tax-free”. The TFSA was established to facilitate lifetime savings needs. It compliments existing plans such as the Registered Retirement Savings Plans (RRSP) and the Registered Education Savings Plans (RESP).

Here are some details from the government’s website:

How the Tax-Free Savings Account Works

• Canadian residents age 18 or older can contribute up to $5,000 annually to a TFSA.
• Investment income earned in a TFSA is tax-free.
• Withdrawals from a TFSA are tax-free.
• Unused TFSA contribution room is carried forward and accumulates in future years.
• Full amount of withdrawals can be put back into the TFSA in future years. Re-contributing in the same year may result in an over-contribution amount which would be subject to a penalty tax.
• Choose from a wide range of investment options such as mutual funds, Guaranteed Investment Certificates (GICs) and bonds.
• Contributions are not tax-deductible.
• Neither income earned within a TFSA nor withdrawals from it affect eligibility for federal income-tested benefits and credits, such as Old Age Security, the Guaranteed Income Supplement, and the Canada Child Tax Benefit.
• Funds can be given to a spouse or common-law partner for them to invest in their TFSA.
• TFSA assets can generally be transferred to a spouse or common-law partner upon death.

How can you argue with tax-free income?

For more information, visit the government’s webpage:

There are a lot of misconceptions about the TFSA. Many don’t know that you can basically hold anything in your TFSA that you can hold in your RRSP.

Here’s a recent discussion from the Financial Post.

Enjoy!

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