What is the single most important thing you can do to create an effective portfolio over time? Pick primo mutual funds? Sniff out every twist and turn of the economy? Find a star adviser?
The answer is none of the above – unless you have a crystal ball! A more important consideration is to establish your asset allocation (AA), according to your time frame, situation and temperament, and stick to it until one or more of those three factors change.
AA is a fancy phrase that simply means a plan, recipe or blueprint for your investments. For example, if you’re a conservative investor, you likely will want a good percentage of your investments in safe stuff, such as guaranteed investment certificates (GICs) and bonds. Your AA might look like this:
- Ten per cent cash
- Fifty per cent bonds or fixed income
- Forty per cent equities (stocks, equity exchange-traded funds or equity mutual funds)
If you hold mutual funds, you need to compare their AA (how the money is invested in the fund) with your chosen AA. Here’s where it can get tough. Investment statements score poorly in detailing AA when the main products are mutual funds.
A given equity mutual fund could hold 100 per cent equities or 60 per cent equities, with the rest in bonds and cash. You can’t rely on the fund’s name or even its category to know how the money is invested. To determine your funds’ AA, go to my last blog, “Figure Out Your Funds – What are they?”
The next step is to compare your fund mix to the AA that works for you. For example, suppose you own two funds with equal amounts of money in each. One has 90 per cent in equities and 10 per cent in bonds, while the other holds 30 per cent in equities and 70 per cent in bonds. Neither fund has a significant amount in cash.
Taken together, your AA is:
- Zero per cent cash
- Forty per cent bonds
- Sixty per cent equities
If you chose the AA example at the top of the blog (10 per cent cash / 50 per cent bonds / 40 per cent equities), you clearly have less invested in cash and more in equities than you want. That means you are going to have to do some tinkering to get to the allocation that suits you.
It gets much trickier if you have seven or eight funds with varying amounts of money in each. However, just eyeballing the AA of the funds and comparing it with your chosen allocation will give you a sense of whether your portfolio is tilted too much or not enough toward one or more of the three main asset classes:
- Fixed income and equities
Research is very clear about AA. Choosing one and sticking to it over time by rebalancing occasionally has a significantly positive impact on return. And, by the way, research also shows that a conservative AA performs just as well over time as a riskier one.
Tip: Spend some time determining your preferred AA. It is a powerful tool and a great guideline for any investment plan.