Canadian Capitalist » Asset Allocation

European Credit Crisis: What to do Now?

Canadian Capitalist — Tue, 09 Aug 2011 03:24:30 +0000

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.

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David Dreman on Tactical Asset Allocation

Canadian Capitalist — Thu, 04 Aug 2011 04:27:11 +0000

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.

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How to Tailor the Sleepy Portfolio for your Investing

Canadian Capitalist — Wed, 23 Feb 2011 03:16:43 +0000

When I started the Sleepy Portfolio, I intended to track it as my personal portfolio benchmark and as such the portfolio allocations reflect my personal investment goals and risk tolerance. I am frequently asked how an investor should tailor this model portfolio to suit their investment goals. In this post, I’ll try and answer some of the questions that frequently arise:

Aggressive Asset Allocation

I started the Sleepy Portfolio in my early thirties and allocating 20% to bonds and 5% to cash is not unreasonable for a young investor. In fact, some would consider the allocation too conservative. Older investors can dial up the “sleep-at-night” quotient by increasing the allocation to bonds. Keeping the age in bonds is a good thumb rule to start with. The bond allocation should then be adjusted for the need, capacity and willingness to assume risk.

Too much allocation to Foreign Stocks

Once an investor has decided how much to allocate to fixed income, the next question is how much to allocate to Canadian stocks. The Sleepy Portfolio allocates 28% of the equity portion to Canadian stocks. Some may consider that too much, others too little (See this post on Portfolio Allocation to Canadian Stocks for some interesting comments). Dan Solin, author of The Smartest Investment Book You’ll Ever Read allocates just 10% to Canadian stocks in his model portfolios based on the belief that investors should hold globally diversified portfolios. Others such as money manager Leith Wheeler say that Canadian investors can get most of the global diversification by allocating half their portfolio in foreign stocks. It is clear that adding some foreign stocks to a portfolio reduces overall risk. Exactly how much is a matter of much debate.

Providing a value and small-cap tilt to the portfolio

The Sleepy Portfolio keeps it simple by holding broad-market, capitalization-weighted indices. There is a large body of evidence that show that investors would have earned a premium for holding small-cap stocks and value stocks in the past. Opinions are divided on whether investors should expect the small-cap and value premiums to exist in the future. I chose to keep it simple in my own portfolios but it is not unreasonable to choose to slice-and-dice equity holdings based on size and value.

The bottom line is that while the Sleepy Portfolio is well thought out (even if I say so myself!), there are not many right and wrong answers in investing. Should you allocate 28% or 35% of your equities to Canadian stocks? Pick one and stick to it. It is impossible to say in advance which option would turn out to be the best answer.

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The Claymore Portfolio Index Allocator

Canadian Capitalist — Tue, 22 Feb 2011 04:04:39 +0000

The Claymore Investment website has a nifty asset allocator tool that lets investors construct model portfolios by mixing different asset classes and examine how they would have performed in the past. The tool is similar to the asset mixer available on Norm Rothery’s Stingy Investor website. The Claymore asset allocator tool though includes asset classes such as REITs and commodities not found in the Stingy Investor website. However, Claymore’s asset allocator doesn’t seem to go as far back in time as Norm’s calculator.

I tried out Claymore’s asset allocator because I was interested in finding out whether it would make sense to add commodities to the Sleepy Portfolio. According to the Claymore asset allocator, between 2003 and 1/31/2011, the Sleepy Portfolio (Cash – 5%, Short Bonds – 15%, Real Return Bonds – 15%, REITs – 5%, Canadian stocks – 20%, US stocks – 22.5%, Developed markets – 22.5%, Emerging markets – 5%) returned 6.62% with a Standard deviation of 9.13%. Allocating 5% to commodities and reducing the exposure to Canadian stocks to 15% would have reduced returns to 6.08% and risk to 8.84%.

The report produced by the Claymore asset allocator also contains a very useful table of correlation between various asset classes. The least correlated assets with Canadian equities are Short-Term bonds (-0.17), Cash (0.00) and Real-return bonds (0.32). In the 2003-10 time period, the asset class with the highest correlation to Canadian equities was emerging markets.

Asset allocation tools are useful to see how mixing different asset classes boosts returns or lowers risk but they should be used with caution. Asset class returns and correlations could vary dramatically from one period to the next.

[Quick reminder: The deadline for entering the UFile Giveaway is Tuesday, 8 p.m. EST.]

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How many asset classes?

Canadian Capitalist — Mon, 08 Sep 2008 02:48:28 +0000

There is a larger question that must be asked in discussing the recent introduction of new Claymore funds tracking global real estate and infrastructure: just how many asset classes does a portfolio need? How much more diversification benefits can real estate, infrastructure, commodities, or even more exotic asset classes provide? In Unconventional Success, David Swensen discusses asset allocation is great detail and provides some guidelines:

A strong equity orientation.
Sufficient diversification through many asset classes.
At least 5 to 10 percent should be allocated to any individual asset class — enough to have an impact on the overall portfolio.
An asset class should not dominate a portfolio — allocate no more than 25 to 30 percent to a single asset class.
The asset allocation decision should be infrequently revisited.

Mr. Swensen’s reasonable guidelines suggest a portfolio composed of no less than 4 and no more than 20 asset classes. A strong equity bias means that the maximum number of asset classes should be far less than 20. The Sleepy Portfolio, for instance, has only eight asset classes — cash, short-term bonds, real-return bonds, REITs, Canadian equities, US equities, EAFE equities and emerging market equities — but the bulk of it (70%) is in equities. The other 30% is already divided between four asset classes; there is simply no room for new ones.

It seems to me (I don’t know of any studies to back up my claim) that once a certain level of diversification is achieved, adding more asset classes is likely to fall prey to the law of diminishing returns. So, as far as the Sleepy Portfolio is concerned, eight asset classes should be plenty enough.

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Are you comfortable with your portfolio?

Canadian Capitalist — Wed, 07 May 2008 03:09:37 +0000

Stocks have staged a significant recovery after falling sharply in the first quarter of 2008. The TSX Composite is up about 19% from its low in January and the S&P 500 is up about 11% from its mid-March swoon. If the lows reached in the first quarter was indeed the market bottom, we can classify the plunge as a severe correction – the TSX was down 18% from its 52-week high and the S&P 500 tiptoed into bear market territory when it was down 20.25% briefly. During the market storm, diversification within stocks wouldn’t have helped; cash and government bonds provided the only refuge.

While the reasonable course of action when markets are correcting is not panicking and staying the course, now may be the time to revisit your asset allocation in light of your reaction to falling stock prices. At times of market turmoil three options are available: (a) sell enough to reach your comfort level (b) stay the course or (c) scrounge every nickel you can find and invest it in stocks. If your inclination was to sell some stocks, your risk tolerance may be less than you originally believed and you may want to increase your allocation to bonds and cash (Now may not be the ideal time to buy bonds either as Government of Canada 5-year bonds are barely yielding 3%).

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How Much in Equities?

Canadian Capitalist — Mon, 11 Feb 2008 04:24:14 +0000

The portion of your portfolio that should be allocated to equities depends on your ability, willingness and need to take risk. One of the factors affecting the ability to take risk is time horizon: investors with a long time horizon can allocate a greater percentage to equities than investors with a shorter time horizon. Larry Swedroe in Rational Investing in Irrational Times provides the following guidelines for the maximum equity exposure depending on time horizon:

0 to 3 years – 0%
4 years – 10%
5 years – 20%
6 years – 30%
7 years – 40%
8 years – 50%
9 years – 60%
10 years – 70%
11 to 14 years – 80%
15 to 19 years – 90%
20 years or longer – 100%

Note that other factors such as your willingness and need to take risk will determine how much you actually allocate to equities. I found this table interesting because it provides a rough guideline of how much could be allocated to equities.

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