Asset Allocation and Building Portfolios
The products on the previous page are the only products you need to create a completely diversified, do-very-little, portfolio that will cost under 15 basis points. And, you don't need to use them all. I suggest that for the growth portion of the portfolio you use either Vanguard or Blackrock products. You don't need to mix the products.
Building Portfolios - Asset Allocation
Step one is to determine your asset allocation or, in plain language, determine the appropriate balance between of growth and safety in your portfolio. Everyone should have a combination of the two. Determining the proper balance is as much art as science. If you don’t completely mess up asset allocation, you can not harm yourself. It is extremely difficult to mess up asset allocation. There are many tools on the internet to help you arrive at a reasonable asset allocation. Here is one. And another. (note that "cash" is short-term fixed income). There are other calculators to be found on the internet.
Growth is ultimately ownership of shares of companies. With growth ETFs, you are a partial owner of each company the ETF invests in just as you would with a mutual fund. Safety is ultimately lending your money and receiving interest. With safety ETFs you are lending your money to companies and governments. Industry jargon equates growth with equity and safety with fixed income. You will see the term "Cash". "Cash" is very short-term fixed income that may or may not pay interest. A chequing account balance is an example of "cash" that does not pay interest.
Growth is synonymous with risk. When you hear "the markets are plunging" they are referring to growth markets. Why would anyone want to assume risk? Or, in other words, what is the reward for assuming risk? Consider someone who starts work at 27, saves $10,000 per year, retires at 62 and redeems $50,000 per year, and lives for 30 more years. Compare an average lifetime annual return of 4% to 6%. At a 4% lifetime average annual rate of return they run out of money by the 23rd year of retirement. At 6%, they pass away on the 30th year of retirement with over $2,000,000 in the bank. A small change in lifetime average annual rate of return has an enormous effect on wealth in the long term. (Are you sure you want to pay 2 percentage points in cost investing the traditional way?)
Two fundamental questions help determine the proper balance between growth and safety. When do you plan on spending the money you are investing? And, how do you react when your investments fall? The first is quantifiable. The second is a hard to determine without experience.
The longer the time until you plan to spend the money the greater the capacity for growth investments. If markets fall you can wait for the inevitable good years. Someone who bought growth investments immediately before the 1987 crash timed their purchase badly. If they held the investment for 30 years they have been well rewarded. They had time to allow growth markets do what they always do in the long-run.
Most people underestimate their horizon. Let’s say you are 60 years old and plan to live to 90. You have a 30-year time horizon. A sizable portion of your money has at least 10 years until it will be spent. A 10 year time horizon is long. On the other hand if the savings are set aside for a specific, non-retirement purpose, the time horizon could be short. For example, you want to buy a $70,000 boat in 3 years and have $50,000 saved. This chunk of money should be 100% invested in safety. If invested in growth markets and growth markets plummet in the next 3 years, bye-bye boat.
Risk tolerance is subjective. No one truly knows their risk tolerance until their savings shrink in a market crash. From Sept 2008 to Nov 2008 growth markets around the world plummeted around 30%. This will happen again. Those who did nothing fared well as the markets eventually roared back. Those who rebalanced and moved money from safety to growth made out like bandits. Those who panicked and moved money from growth to safety watched their savings decline and then grow at a paltry 1 to 2.5% since. How will you react and what will you do? If you've experienced a falling market you may have panicked and you may have learned. If you haven't experienced a falling market you are guessing your tolerance to risk. It is difficult to watch your savings decline in value day after day and month after month. It is even harder to rebalance savings away from safety towards growth as growth markets are falling.
Periodic rebalancing is necessary. The decision on the balance between growth and safety was made with purpose. If growth or safety outperform, the balance between growth and safety will be off. It is necessary to bring the allocation back to the appropriate mix. Rebalancing is like a buy-low, sell-high strategy. Buy-low means investing in the underperforming investment. If growth is plummeting, you rebalance into growth away from safety. If growth is outperforming safety, rebalance into safety. Periodic rebalancing within growth is also necessary. If Canadian growth outperforms US growth, rebalancing dictates selling Canadian growth and buying US growth. It is less necessary to rebalance within safety and is impossible to rebalance GIC holdings before terms mature. Rebalancing is simpler than it sounds, especially if you are contributing or withdrawing. Contribute to underperforming investments and withdraw from outperforming investments.
It is necessary to periodically evaluate the appropriate balance between growth and safety. Each passing year means your time horizon is one year shorter.
Once you decide upon the balance between growth and safety the next decision is how to allocate your Growth portfolio.
Building Portfolios - Asset Allocation within the Growth Portfolio
The longstanding rule of thumb for Canadian investors is 1/3 of your Growth portfolio should be invested in Canadian companies, 1/3 in US companies, and 1/3 in rest of the world companies. The rest of the world category should be split 2/3 in developed markets and 1/3 in emerging markets. This is reasonable. We suggest slightly less in Canadian equity and rest of world equity and more in US equity like 30% Canadian equity, 40% US equity, and 30% rest of world equity with slightly less in emerging markets. Capitalism works and the US is the largest capitalistic nation. Vanguard Canada all equity portfolio has a 30% Canada 40% US 23% Developed non-North America and 7% Emerging Market allocation. This is reasonable. Blackrock has more in the US and less in Canada.
There are fundamental reasons to diversify geographically away from a portfolio of solely Canadian companies. The Canadian economy has a heavy weighting of companies operating in the basic materials and resource sectors. We are blessed with an abundance of virtually all natural resources. Banks also comprise a large sector of our economy. Investors need exposure to other industries that are underrepresented in Canada. Canada is not home to a multinational consumer discretionary company like a car company, nor a consumer non-discretionary company like a Proctor and Gamble, nor a technology company like a Google. Blackberry is a shadow of its former self. Canada is not home to a major industrial company like a Boeing or Caterpillar.
FYI. One third or 30% of savings invested in Canadian companies is a massive overweighting of Canadian companies. The value of Canadian companies combined represent close to 5% of the value of all companies in the world combined. This isn't a knock on Canada. Four or five percent is quite high given that our population is substantially less than 4 or 5% of global population.
Building Portfolios - How To Build a Completely Diversified Growth Portfolio and a Simple Safety Portfolio
Low Cost Growth Portfolio
30% Either Vanguard FTSE Canada All Cap Index ETF or iShares Core S&P/TSX Capped Composite Index ETF
40% Either Vanguard Total Stock Market ETF or iShares Core S&P Total US Market ETF
23% iShares Core MSCI EAFE ETF
7% Either Vanguard FTSE Emerging Markets ETF or iShares Core MSCI Emerging Markets ETF
This portfolio has an MER (Cost) of 5.45 basis points. For example, if the portfolio grows by 7% (700 bps) pre-cost in a year, you get 6.94.6%.
Low Cost Safety Portfolio
50% Vanguard Canada Canadian Short-Term Bond ETF or iShares Core Canadian Short-Term Bond ETF
GICs have a quoted return. The cost to the ETFs is between 11 and 13 basis points. Total cost the the Safety portfolio is 6 basis points.
Combining the Growth And Safety Portfolios to Achieve your Asset Allocation
Let's say you determine the proper asset allocation is 60% growth and 40% safety. If we combine both portfolios with 60 /40 growth / safety split, total MER is 5.45 basis points x 60% + 6bps x 40% = 5.67bps. If the portfolio grows by 5% pre-cost, you get 4.94%. A similar portfolio similar managed actively through a financial advisor would cost at least 150 basis points. BYOFA reduces your cost factor by over 26 times.