Asset allocation really is the bedrock to building a great portfolio. At the core, asset allocation is defined as the way you divide up the investments in your portfolio. It’s an often-neglected aspect of portfolio management among self-directed investors, but it can play a crucial role in everything from risk management to long-term portfolio performance. Here’s why.
To begin with, there are three main traditional asset classes: cash; fixed income; and equities. Some investors may want to include a fourth asset class that includes, among other things, real assets such as real estate and commodities. At the very least, though, to build an effective portfolio, you really do need to have exposure to all three of the main asset classes.
This is something that a number of people tend to lose sight of, particularly when we are in the midst of an extended market rally. For example, after the global credit crisis in 2008, many of my clients, both individual investors and their advisors, told me that they didn’t believe in asset allocation anymore because their portfolios had lost 35%, 45%, or even more during the subsequent bear market.
The perils of narrow diversification
When I ask what their portfolios held, I learned it was usually always a mix of about four or five different equity funds. Trouble is, that is not effective asset allocation. What these investors had done was to diversify within one single asset class, namely equities. While that type of diversification is important, it is too narrow and will not provide a cushion against a broad-based market selloff.
As an illustration, take a look at the chart below, which compares two portfolios. The first is an all-equity portfolio consisting of 70% S&P/TSX Composite Index and 30% MSCI World Index. Between May 2008 and the February 2009 low, it dropped by 40%. The second portfolio allocates 40% of the portfolio into the DEX Bond Universe Index. In this case, the peak to trough drop was only 24%.
This shows that by following even the most basic definition of asset allocation, you can help reduce the impact of market declines. This is because most of the time, the different asset classes do not move in tandem (they are not perfectly “correlated” to use financial jargon). When equities are higher, bonds tend to be flat or move lower. Conversely, when bonds are rallying, equities are usually on the decline. Understanding this relationship is what makes asset allocation work.
Your risk tolerance defines asset mix
Generally, most of the return of your portfolio will come from your equity holdings. While you may be tempted to add more equity exposure, you need to understand that equities tend to carry higher potential risk. Fixed income and cash are generally less risky than equities and are best used as a way to help reduce the overall volatility of the portfolio. The less risk you are comfortable with, the higher your exposure should be to bonds and cash.
In the current environment, I don’t expect that fixed income or cash will generate much return in the near to medium term. But because they tend to move opposite of equities, they can be a nice shock absorber when the equity markets decline (and they always do at some point).
In addition to having exposure to the various asset classes, it is also a good idea to diversify within each asset class. For example, within equities, you’ll want to have some Canadian, U.S., and international stocks. You may also want some small caps and other specialty holdings to help diversify further. For your bond holdings, you will want to have government bonds, corporate bonds, and quite possibly global and riskier high yield bonds.
Below are some sample asset mixes that I tend to use as a guideline when setting up client portfolios. These can hopefully provide you with some ideas on what asset mix may be right for you based on your risk tolerance.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update, offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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