Asset Allocation

Reader Question on Bond Allocation

October 22, 2013

17 comments

A reader recently sent in this question on asset allocation:

I’m an investing newbie. Last year, I started investing in all four TD e-Series Mutual Funds in my TFSA on my own after reading your posts. I currently have a 30 percent allocation to bonds. Should I keep investing in TD Canadian Bond Index (e-Series) with interest rates forecasted to go up? Or should I cut down on the bond fund and allocate more into the other stock index funds?

Bonds have been terrific investments for a long time now. As of Sept. 30, 2013, Canadian bonds (as measured by the DEX Universe Bond Index) have returned 5.63 percent over 5 years and 5.22 percent over 10 years. Canadian stocks (as measured by the S&P/TSX 60 Index), on the other hand, had returned 3.72 percent and 8.45 percent respectively during the same time periods albeit at a much higher volatility including a significant stock market crash. Therefore, the natural inclination of many investors would have been to look at the recent past and concluded that they are better off in bonds than in stocks. Asking whether one should avoid an asset class after it has experienced a huge run up if therefore an insightful one.

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European Credit Crisis: What to do Now?

August 8, 2011

27 comments

In past market downturns, I’ve always maintained that an investor should stay the course, as long as she has a suitable asset allocation that she is comfortable with. Even though markets have been losing big chunks of their value seemingly every single day, the mantra remains the same: hold the course.

However, a number of investors are unfortunately finding out only now that their asset allocation was far too aggressive. What should these investors do?

The answer is easy for investors who find that they have an asset allocation that is inappropriate for their financial goals. For example, an investor who finds that the education savings of their child who is attending school pretty soon is mostly invested in stocks should take action now. She should reduce the risk of the portfolio right away by selling some stocks and parking the proceeds in savings accounts or cashable GICs. For all we know, it could get a lot uglier and it may be better to take the lumps now and preserve whatever capital is left.

It is harder to think of a suitable course of action for investors who have the ability to take risk but are only now finding out that their risk tolerance is a much lower than they had earlier estimated. There are no easy choices. They could sell some stocks now but they may be locking in their losses but selling may also mean that they don’t take an even more drastic action should stocks fall even more. Or they could resolve to reduce risk at the first available opportunity and plan to endure the current downturn. The obvious risk here is that things get a lot worse and they sell at an even worse time down the road when they feel they can’t take the heat anymore.

Personally, I’m opting to hold the course. My rebalancing spreadsheet indicates that the bond portion has increased to 2.5% of the portfolio. If current trends continue, it will soon be time to sell some bonds and buy some stocks. Until then, I’ll just be content to watch the horror show on Bay Street from the sidelines.

David Dreman on Tactical Asset Allocation

August 4, 2011

10 comments

Some investors advocate tactical asset allocation (TAA) or the practice of adjusting the portfolio mix of stocks, bonds and cash to economic and/or market conditions. In his book Contrarian Investment Strategies, David Dreman notes that while it’s true that an investor who could successfully TAA could grow money on trees, TAA is difficult to practice because “real market movements give dozens of signals, madly flashing buy, sell and hold all at once”. Mr. Dreman then compares the performance of mutual funds that employ TAA to their benchmark and finds the results disappointing.

Does it work? The figures are not encouraging. Figure 3-1, taken from Lipper and Morningstar data, shows the returns of 186 asset allocators for the 12 years to September 1997 compared to the S&P 500 and the average of all domestic equity funds. The period covers a good part of the bull market, as well as the 1987 crash, and the sharp downturn in 1990. This was the ideal time for market timers or asset allocators to prove their mettle. They should have got you out before the 1987 and 1990 debacles and back in on time to ride the resurgent bull. Had they succeeded, you would have outperformed the market handily.

As the chart shows, heroes they ain’t. While the market surged 734% over the entire period, and the average equity fund moved by 589%, the asset allocators increased only 384%, about half the gain of the averages (all figures are dividend adjusted). Tactical asset allocation has obviously not set the world on fire. In fact, it’s downright awful, even in the periods where asset allocators claimed they swept the field.

The prosecution rests.