Chiropractic + Naturopathic Doctor

Features Business Management
The key decisions


July 18, 2013
By Paul Philip

Topics

In this second part of a series on the key decisions every investor needs to make, we examine “the asset allocation decision.”

In this second part of a series on the key decisions every investor needs to make, we examine “the asset allocation decision.”

It is vital to have a good understanding of risk to be able to make an informed decision regarding which general asset classes to include in your investment portfolio. Bay Street and the financial media often focus on an investment’s potential return (how much you might make on that investment) rather than the risk you must take in order to achieve that return. A core understanding of risk and the relationship between risk and return is necessary for any prudent, long-term investor to make smart investment decisions.

Advertisement

For long-term investors there are two general types of investments that make up a portfolio:

  1. Equities (or stocks) – are an ownership interest in a company. If the company does well, as a shareholder you should benefit from its rising stock price. The company might also pay a discretionary dividend to shareholders in the form of cash or more shares of stock. If the company does poorly, its stock price might go down, causing your shares to decline in value. There are many factors that can affect a company’s stock price, many of which are completely external to the company itself. In general, equity investments are considered higher risk/higher expected return investments.
  2. Fixed income (or bonds) – are an IOU or a loan to an entity such as the Canadian government, a province, or a company. Bonds are contractual obligations that usually involve interest payments paid by the borrower at regular intervals and, ultimately, the return of your initial investment at maturity date. Bonds are generally considered to be lower risk/lower expected return investments (especially high-quality, short-term bonds).

Risk and return are related
Although Bay Street and the financial media encourage us to believe that we can find a “free lunch” or a market pricing error on investments, these opportunities are very difficult to exploit. In other words, there are no low risk/high expected return investments.

Here’s why – if an investment offered a disproportionately high return for the risk it involved, word would spread and others would try to capitalize on it. This additional demand would result in the price of the investment being driven up to the point where its expected return is commensurate with other investments of similar risk.

This is how free markets work. Each day, the prices of tens of thousands of publicly traded stocks and bonds around the world continuously adjust to reflect new information or developments.

So if there are very few pricing errors on investments, what will be the primary determinant of your investment performance? Stockbrokers and the financial media would have you believe that investment results are mostly determined by how successful you (or they) are at: (1) timing, that is, when to get in and out of the market, or (2) picking the “right” individual stocks and bonds to own, or (3) finding the next top-performing manager or mutual fund (or all of the above).

Wrong!

Study after study shows that these factors actually make a negative contribution to the total return level of a diversified portfolio. For the most part, these activities waste your time, cost you money and reduce your return. The truth is your investment portfolio is just like a bar of soap – the more you touch it, the smaller it will get!

It is critical to understand that the primary driver of investment returns is risk, specifically the riskiness of (and the relationship between) the asset classes you use in your portfolio and how you allocate your investment dollars among them. This is the asset allocation decision.

How important is it?
Approach the asset allocation decision first by focusing on your desired mix of cash, bonds and stocks. This is the single most important investment decision you will make.

Cash
As a guideline, the percentage of assets invested in cash equivalents – which are safe, easily accessible, short-term investments such as treasury bills, bank CDs, and money market funds (lowest risk/least return) – should be based on how quickly you might need to access these funds. Any money required in less than one year should be invested in cash equivalents.

Bonds (lower risk/lower return) and stocks (higher risk/higher return)
Since stocks are riskier than bonds, it follows that they should provide higher returns in the long run. Bonds, therefore, should be viewed as a tool for reducing the volatility of your portfolio. As such, it makes sense your bond holdings be of higher quality and shorter maturity issues, such as short-term Canadian t-bills, government agencies and the high-quality corporate bonds. These are the safest and least volatile fixed-income asset classes.

There are two reasons you should include bonds in your mix:

  1. Your emotional tolerance for risk. There will be years when stocks go down 20 per cent, 30 per cent, or more. It can be difficult to withstand such short-term pain and you want to be sure that you do not set yourself up for failure. Studies have clearly shown that investors tend to panic and sell at or near the bottom of market decline, causing them to miss the subsequent recovery. For example, in 1973 and 1974 a globally diversified portfolio of stocks would have been down about 19 per cent and 23 per cent, respectively. Investors who panicked and sold likely missed the subsequent recovery in 1975 and 1976 when the same portfolio was up approximately 41 per cent and 28 per cent, respectively. A similar story unfolded after the market declines of 2000-2002 and 2008. After the 2008 financial crisis, those who panicked and “cashed out” missed the significant recovery that has since taken place and many are now still on the sidelines dazed and confused and left wondering what to do. Investors need to understand their emotional ability to “stomach” occasional down years in equities upfront. With a portfolio that is properly allocated to match your risk tolerance, you will be more likely to maintain your investment discipline and enjoy better investment returns over the long term.
  2. Your age. A younger investor can be a better candidate for an asset mix more heavily weighted toward equities. The younger investor will most likely not need to withdraw money from their investment portfolio for decades – their future earning capacity is their greatest asset – and they should be better able to emotionally withstand the short-term ups and downs of the market. In contrast, a retiree whose earning capacity is limited and who is withdrawing part of their portfolio each year for living expenses should not be too exposed to stocks and a potential extended stock market downturn. An older investor may want to lessen the volatility of their portfolio with more exposure to bonds.

In summary, the biggest determinant of your investment experience hinges on your asset allocation decision. The truth is, for most this is an area where professional guidance should be sought. A qualified advisor will have the tools, experience and perspective to help you determine what’s right for you. It is the advisor’s responsibility to be there not only at the beginning but also as your life unfolds and adjustments need to be made along the way. When done right, your advisor will be one of your most important relationships in life. Take care to find the right person to fill this important role.

No doubt your family’s financial future is important to you. Procrastination kills financial freedom. Make it a priority to learn as much as you can and to take control of your finances today!


Paul Philip, CFP, CLU, has been advising hundreds of chiropractors across Canada on building and protecting their wealth since 1992. His firm, Financial Wealth Builders Inc. is located in Toronto, Ontario. To learn more about building your wealth visit www.fwb-inc.com or contact Paul at paul@fwb-inc.com or 1-866-735-5581.


Print this page

Related



Leave a Reply

Your email address will not be published. Required fields are marked *

*