It is not the beauty of a building you should look at; it’s the construction of the foundation that will stand the test of time.
~David Allan Coe
This chapter is all about the foundation of your portfolio. This should be the core, or in other words, the most important part of your investing journey. As you will discover in this chapter, your asset allocation will be responsible for 70%+ of your investment returns. Thus, if you don’t take the time to build your asset allocation right, your whole retirement plan can go sideways.
Your route to retirement
Have you ever taken the time to write down your retirement plan? This may sound simplistic and boring, but it is in fact, even more important than building your portfolio. If you don’t have a retirement plan, how can you build your investment strategy? It’s like not knowing your destination but already looking for a means of transportation. I bet you will feel more than a bit discouraged if you bought a bicycle and you want to reach Hawaii!
In the best-case scenario, you already know a highly qualified financial planner that has done or will do this planning for you. However, if you want this to happen, you will either have to pay him for his work, (fee-based financial planners charge for plans but give unbiased information as they don’t sell investment products) or invest with him (then you have to be careful to not fall in the world of managed funds with higher fees). The advantage of having a plan done by a certified planner is that he will cover not only your investing strategy, but the following fields as well:
- Personal finance: he will look at the way you setup your budget, your bank account, mortgages and other debts, etc.
- Insurance: he will calculate how much you need in insurance to cover your needs.
- Estate planning: he will give you advice regarding your testament.
- Tax planning: he will give you insight into optimizing your finance to save maximum in taxes.
- Investment: he will help you make the right asset allocation and invest your money according to your goal.
- Retirement planning: he will write a plan including how much money you need to retire comfortably, and how much you need to save to reach your goal. He will also run multiple scenarios with different investment returns. His software is powerful enough to include various events in your plan such as the sale of a property, adding rental income, adding various sources of revenues, etc.
- Legal aspects: he will look at legal aspects such as your marital status and what will happen in an event of a separation.
If you are not ready for a full plan, Vanguard and Market Watch offer free online retirement income software. This will help you find out how much you need to save and how much return you need to get to achieve your retirement goals. Remember, if you can’t make it with the numbers you have in mind, there are three areas you can play with:
- Amount of money saved: the earlier you start saving, the bigger your nest will become. You can also look at your budget to increase your monthly saving rate.
- Your investment rate of return: the bigger your investment return is, the faster you will reach your goal. However, this number should not be determined by you, but by your asset allocation. You should refer to a financial planner to get an idea of realistic rate of returns.
- The retirement age: the longer you wait to retire, the more money you will have to spend. Keep in mind that your life expectancy is reaching toward 90. Retiring at 55, may not be the best idea.
Risk tolerance
Risk is a crazy thing. Take on too much and you either crash and burn or make out like a bandit. Take on too little and you either float along or once again, make out like a bandit. The “trick” is figuring out the happy balance that you will be comfortable with. I have spent some time determining my risk profile and have asked myself several questions…
- Do I prefer stability over high returns?
- How can I make money without risking too much?
- Do I feel bad when all my friends are making double digit returns and I’m not?
- My portfolio is down by 27% (2008), it hurts… but how bad does it hurt?
- Should I sell my stocks and change my strategy?
- When is the right time to invest in the market? I don’t want to invest right before a crisis!
The funny thing is that I don’t always have the same risk profile. It varies depending on why I am investing. I have different answers to these questions depending on which account I am investing in. For example, my retirement account is fairly aggressive. Therefore, when I invest in this account I’m 100% invested in stocks. I’m in the stock market for the long run and don’t fear a market crash.
On the other hand, I’m also putting money aside for my children’s education. I have added 25% of fixed income to this portfolio because I don’t want to risk losing too much in this account. Furthermore, I’m saving money for my nephew’s education in another account. Since this money is set aside for a gift, I have put 75% in fixed income and the rest in equity. As you can see, I manage three portfolios from 100% in stocks (retirement account) to as little as 25% in stocks (for my nephew).
The time horizon for your project (that you previously defined) will also affect your investor profile. If you are planning a trip in 9 months, skip the stock market and put your money in a savings account. If you are about to retire, you can still take a good amount of risk, as chances are you will be living off your investment for 30 years (I bet you didn’t think of this one, huh?).
For each account, you should ask yourself the same questions. Contextual reasons may encourage you to take more or less risk. Here’s a quick definition of different investment profiles:
Conservative:
You have a need for a predictable flow of income or have a relatively short investment horizon. Your tolerance for volatility is low and your primary goal is capital preservation.
Moderate:
You seek a regular flow of income and stability, while generating some capital growth over time. Your tolerance for volatility is moderate and your primary goal is capital preservation with some income.
Balanced:
You’re looking for long-term capital growth and a stream of regular income. You’re seeking relatively stable returns, but will accept some volatility. You understand that you can’t achieve capital growth without some element of risk.
Growth:
You can tolerate relatively high volatility. You realize that over time, equity markets usually outperform other investments. However, you’re not comfortable having all your investments in equities. You’re looking for long-term capital growth with some income.
Aggressive:
You can tolerate volatility and significant fluctuations in the value of your investment because you realize that historically, equities perform better than other types of investments. You’re looking for long-term capital growth and are less concerned with shorter term volatility.
To figure out your investment profile and find the answer to this tricky question, there is nothing better than answering a questionnaire. I’m sure you have answered this sort of thing before. They may seem cheesy sometimes, but trust me; they definitely help you put things into perspective. Based on my experience, I feel that most people believe that they are braver than they are! The real investor in you tends to show up when the market crashes. Speaking of which, I found a great questionnaire over @ Vanguard. I am in no way linked or paid by this group to refer you to their risk profile questionnaire. However, I believe it is one of the best around since they help you think about 11 different questions that include practical facts that happened in 2008. With no surprises, I finished mine with a 100% stock profile:
Asset allocation
Asset allocation is simply the combination of various types of investment products that make up your portfolio. It starts with the important decision you made earlier: the split between stocks and fixed income.
However, asset allocation gets a little more complicated than that. It can actually go from uncomplicated to complex: depending on the time you have available to manage your portfolio and the amount of diversification you are looking for.
Here is a quick example of an asset allocation, assuming our investor is 30 years old. We could simply use the “100-minus-your-age” rule to setup your asset allocation. Remember, as a 30-year-old investor our split between stocks and fixed income using our simple formula would be 70% in stocks and 30% in fixed income:
| Asset Class | % of Portfolio |
| Stocks: U.S. Total Market | 35% |
| Stocks: International Market | 35% |
| Fixed Income: U.S. Treasury Inflation Protected Securities (TIPS) | 30% |
| 100% |
Importance of Asset Allocation
Why am I spending time on asset allocation? Simple – it is the most important aspect of your portfolio. This is because amongst all the important inputs involved in the success of a portfolio, asset allocation accounts for 70%.
Other important factors include 20% for the sub-asset allocation. This includes things like the market cap and value versus growth. So if we read that right, 90% of the returns of a portfolio are determined by the overall asset allocation of the portfolio. The importance of asset allocation seems pretty clear now doesn’t it!
Keep it Simple
To the maximum extent possible, we should apply the KISS principle to our investment accounts. KISS simply stands for “keep it simple stupid”. In building your core portfolio, it helps to keep things as simple as possible for tracking purposes, tax planning, and rebalancing efforts required later on.
Simple is a relative term, as one person’s definition of simple may not be the same as the others’. For some, this may mean holding two assets – one total market stock index fund and one short-term bond fund. For others it may mean holding three separate equity funds and two bond funds. There are no hard and fast rules around what individual investors should choose. My suggestion is to choose the number of asset classes that you have the time to manage.
Asset Classes to Consider
An asset class is simply one of the various types of investments you can hold in your portfolio. There is a wide-variety of asset classes to consider.
When it comes to choosing asset classes for your portfolio, diversification is the name of the game. The more you spread out your assets across different areas, the more diversified your portfolio becomes and the less risk you take on.
However, at the same time, the more asset classes you choose, the more complex your portfolio becomes, and the more work required to maintain it. When you build your portfolio you will assign a target allocation to each of your chosen assets, and the more assets you have, the more work it will take to ensure it aligns to your target allocation. In addition, each additional asset brings on addition fees that can corrode your investment returns (more on that later).
There is an endless selection of assets you can include in your portfolio. However, as I discussed earlier, it is probably in your best interest to keep things simple. As such, I am going to discuss with you the major asset classes that I have seen most often, and ones that I consider for my own portfolio.
Equity Components
When investors talk about equity, most often they are talking about stocks. Essentially, it is the capital raised by a corporation through the issue of shares, entitling holders to an ownership interest – a la the equity.
Equities are a broad group and can be further broken down into a number of smaller allocations. Here are the most common ones you will be faced with:
| Equity Asset Classes | Definition |
| Total Market | The entire stock market and all stocks that it is made up of |
| Large-Cap | Stocks that have a market-cap of more than $5 billion |
| Value | A stock that tends to trade at a lower price relative to its fundamentals (dividends, earnings, sales, etc.) |
| Small-Cap | Stocks that have a market-cap between $300 to $2 billion |
| Real Estate Investment Trust (REIT) | A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages |
| International | Stocks that are located in a region outside of your own county |
| International Value | An international stock that tends to trade at a lower price relative to its fundamentals (dividends, earnings, sales, etc.) |
| International Small-Cap | An international stock that has a market-cap between $300 to $2 billion |
| Emerging Market | Emerging markets are nations with social or business activity undergoing the process of rapid growth and industrialization |
Fixed Income Components
The fixed income portion of your portfolio is designed to reduce volatility and preserve capital. They are not intended to provide large returns.
Although there can be just as many fixed income choices as there are equity assets, the ones that I believe fit in the average investor’s portfolio are limited to three. These are the assets with the lowest levels of risk.
| Fixed Income Asset Classes | Definition |
| U.S. / Canadian Short-Term Bonds | Bonds that are short in duration – usually less than 1 year |
| U.S. Treasury Inflation Protected Securities (TIPS) | Treasury Inflation-Protected Securities (TIPS) are inflation-indexed bonds issued by the U.S. Treasury |
| Canadian Real Return Bonds | Real Return Bonds (RRBs) are bonds issued by the Government of Canada, and pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation |
Portfolio example
In the previous chapter you learnt about various asset classes that can be included in your portfolio. You can now use the following examples to inspire your own investment model. Since I’m Canadian, I have included portfolios for both American and Canadian investors. I have decided to give you three examples that range in complexity: from ‘dead simple’ to ‘analyst-like-complicated’. It’s up to you to determine which portfolio suits your needs best! Remember, the more assets you add, the more diversified, or less volatile your portfolio will become. However, at the same time, diversification will also make management of your portfolio more time consuming.
Dead Simple
This simple asset allocation model keeps asset selection to a minimum, while providing good diversification. It is important to note that this portfolio contains domestic as well as international assets. The world is much larger than just the U.S. and Canada, and international assets should be incorporated to create a well diversified portfolio. This ‘dead simple’ portfolio is the kind of portfolio you can start with if you are new to investing and hope to learn as you go along.
| U.S. Investors | Canadian Investors |
| U.S. Total Market | Canadian Large-Cap |
| International | U.S. Total Market |
| U.S. Treasury Inflation Protected Securities (TIPS) | International |
| Canadian Real Return Bond |
The “4 holdings aren’t enough” Portfolio
This portfolio is a bit more complicated and includes some value and small-cap components in the mix. It requires some extra work to maintain, but adds more diversification. It is a good option for portfolios over $50,000.
| U.S. Investors | Canadian Investors |
| U.S. Total Market | Canadian Large-Cap |
| U.S. Small Cap | U.S. Total Market |
| International Value | U.S. Small-Cap Value |
| International Small-Cap Value | International Value |
| U.S. Treasury Inflation Protected Securities (TIPS) | International Small-Cap Value |
| Canadian Real Return Bond |
The Analyst-like complicated Portfolio
This portfolio is the most complicated of the three. This is primarily because it includes a higher number of funds and incorporates additional asset classes such as emerging markets and REITs. It would suit more analytical investors with large portfolios.
| U.S. Investors | Canadian Investors |
| U.S. Total Market | Canadian Large-Cap |
| U.S. Total Market | Canadian Large-Cap Value |
| U.S. Small Cap | Canadian Small Cap Value |
| U.S. Small Cap Value | U.S. Total Market |
| Real Estate Investment Trust (RETI) | U.S. Small Cap |
| International Value | U.S. Small-Cap Value |
| International Small-Cap Value | Real Estate Investment Trust (RETI) |
| Emerging Markets | International Value |
| U.S. Short Term Bond | International Small-Cap Value |
| U.S. Treasury Inflation Protected Securities (TIPS) | Emerging Markets |
| Canadian Real Return Bond | |
| Canadian Short Term Bond |
Management tips
Now that you have built your portfolio, you can’t just lay back and relax until you reach retirement. While it may be true that the most difficult part of the work is done; you must continue to tweak various factors as you advance in your investing journey. I have created this section to give you some portfolio management tips so you start off on the right foot!
#1 Rebalancing is the key: As the market evolves over time, you will see some asset classes outperforming others. For example, suppose you invest 50% of your $100,000 portfolio ($50,000) in the SPY following the U.S. market. The SPY goes up by 100% in five years but you never rebalance. All the other asset classes show 0% growth. As a result, five years later, your portfolio will show $100,000 in SPY, which will now be 67% of your portfolio. In the event of a market crash, your portfolio will be at great risk. In order to avoid excessive transaction fees, you should perform a rebalancing procedure every 6 months. This is enough to capture any movement anomaly a bull or bear market would generate.
#2 Review your retirement plan yearly: In my previous life, I was a financial planner for a decade. During this time, I have reviewed and modified many of my clients’ plans. Was it because the original plan wasn’t good enough? Nope. It was because life changes a lot faster than you might think. A wedding, the coming of a new child, a divorce, the idea of buying a rental property or selling your vacation property early; these are all factors that keep changing in one’s life.
#3 Remember that ETFs are not safer than any other investment: It is true that ETFs are more flexible and efficient than most investment products on the market. However, ETFs don’t make miracles, and your portfolio is likely to suffer from market volatility.. Since they are easy to trade during a bad day, you will have to remember that you are investing for the long haul. Don’t let the “noise” in the stock market distract you from your course.
#4 Always review your ETFs composition: Like other investment products, ETFs evolve all the time. What is the best ETF today may become completely obsolete 5 years from now. By reviewing your ETFs selection each year and by comparing features offered by newer products, you will be sure to have the best performing portfolio for your asset allocation.
#5 Pick Simple ETF’s: Your core portfolio ETF selection should focus on simple ETF strategies. The more simple the ETF, the easier it is to compare with similar products. This forces issuers to offer the ETF at an extremely competitive price. When you start adding multi-factors, selecting industries, etc, it becomes much more difficult to compare. This opens the door to higher fees. I would focus on very broad indexes on very common indexes (S&P, MSCI for example) as a starting point.
#6 Resist The Temptation Of Over-management: I generally believe in having a core retirement portfolio with strict rules. Along with that I have a side portfolio that could hold ETFs as well as dividend stocks or any other asset. Why? Because at some point, we all feel like being part of the action in the market or taking a bet on a specific company. When you want to take a risk, it helps if it is through a segregated account.
#7 Switching ETFs Should Be Done Carefully: Every year, new ETFs are launched, and in some cases, that opens opportunities for lower priced ETFs. I would not recommend automatically switching to cheaper ETFs. Why? Because there will be costs involved in switching, such as commissions, spreads, possible tax implications, etc. In the end it might end up costing more than the 1-2bps that you would save annually. I’m not saying you should never switch. What I am saying is that there are ways to optimize such moves, which we’ll go over on ETFsRock.com.