Determine Your Porfolio’s Asset Allocation

Note: Step 7 is one of the most complicated steps in the Portfolio Design process. It is not a quick read, and it will involve you doing some math.  There is no black and white answer to this step as it is different for everyone.  The asset allocation one person decides will be unique to that person’s own financial circumstances. So be prepared to do some work in this step! 

Note: In the section Single Asset vs Multi Asset Portfolios, we have provided a more detailed and specific discussion about finding an asset allocation (Bonds, Common Shares, Domestic and International) that strikes the optimal balance between minimizing a portfolio’s volatility and maximizing a portfolio’s rate of return. The support for this discussion is drawn from Russell Investments investment data. Russell Investments has been tracking investment portfolios with differing asset allocations for decades and the company shares its data with investors annually.

Generally, in the investment world, asset allocation is a phrase used to describe the amount of money invested in different investments or asset categories.  And generally it is recommended that when it comes to asset allocation, don’t put all your eggs in one basket. So before we actually begin Step 7 let’s first describe what asset allocation is.

When discussing asset allocation, there are actually two levels of allocation to consider, as outlined below:

• between investment types
• between account types

Asset allocation between investment types

Let’s say you have $100,000 in savings and these moneys are invested as follows: $50,000 invested in bonds, $25,000 invested in mutual funds, and $25,000 held as a cash balance. How you divided your money is called your asset allocation.

Note: A person’s asset allocation can be expressed in dollar amounts or in percentage terms. If the above example asset allocation were expressed in percentage terms, then your $100,000 in savings would have an asset allocation of 50% invested in bonds, 25% invested in mutual funds, and 25% invested as cash.

Three basic investment types

Individual investments are typically assigned to one of three basic asset categories: Cash/Cash Equivalents, Fixed Income, and Growth. In general, for an individual investment to be assigned to one of the three basic asset categories, each investment must possess certain investment characteristics and features, for example:

1. Cash or Cash Equivalents: For an investment to be classified as Cash or as Cash Equivalent, the savings are held as a cash balance in an account or it provides a high level of safety for the capital amount, pays a reasonable income while invested, and it can be sold easily at any time or the investment has a very short-term maturity. At maturity, the issuer guarantees to return the investor’s capital upon the maturity date.
2. Fixed Income: For an investment to be categorized as Fixed Income, the investment should have a set maturity where the investor’s invested capital will be returned to them and the investments should have a set, regular annual income. The investment’s market value is typically influenced by the credit rating of the issuer, the current interest rate environment and the investment’s liquidity. Fixed Income investments do benefit from the issuer’s profitability or investor’s enthusiasm for the issuer’s industry or sector. In some cases, as with preferred shares, the investment may be missing a maturity date, but its individual features and the market’s valuation of the investment is closer aligned to a Fixed Income investment than it is to a Growth or Cash Equivalent investment. As a result, it is classified as Fixed Income for asset allocation purposes.
3. Growth: For an investment to be categorized as Growth, the investment will not have a maturity date where the investor’s capital is returned to them. There is no issuer guarantees on the monies invested. The market value of the investment will fluctuate dependent upon the issuer’s profitability, the economic and investment environment and the popularity of the issuer’s industry with investors. The investment will not pay an enforceable income payment to the investor. The investment may or may not pay an annual income, but the payment is at the discretion of the issuer and, as such, the investment’s annual income payments can be increased or decreased at the issuer’s discretion.

Note: The most common asset or investment categories are listed and grouped below:

Note: For a more detailed discussion of the different investments, see our section Class Room: Investment Types.

Remember: Your chosen asset allocation will influence the following outcomes:

• The amount of your savings exposed to the risk of capital loss
• The potential for future capital gains
• The amount of fluctuation or volatility in the market value of your investments
• The amount of regular dividend and interest income generated by your portfolio
• The portfolio’s success or failure in achieving your Required Average Annual Rate of Return
• The amount of your time and energy needed to maintain the integrity of the portfolio, and
• Ultimately your success or failure in attaining your financial goals

Risk and volatility within the different investment types: a visual

As the figures below illustrate, in general, each investment category and type of investment will possess its own investment characteristics in terms of the investment’s safety (see first figure below: Safest, Safer, Least Safe), market price volatility (see second figure below: Least Volatile, Less Volatile, Most Volatile), investment income stream (see third figure below: High Income Tax, High Income Tax, Lowest Income Tax), potential for capital gains or losses, and the level of taxation when held within a taxable account.

In addition to the grouping of individual investments within specific asset categories, individual investments are also categorized according to the level and type of guarantees provided by the investment issuer and they are categorized by the level of income tax applied by the Canada Revenue Agency (CRA) when the investment is held within a taxable account.

Example:  If we create a visual sliding scale based upon an investment’s guarantee on the investor’s capital, we can create the following scale that ranks an individual investment’s potential to earn capital gains or loses:

If we create a sliding scale based upon an investment’s market price fluctuations or volatility, we can create the following scale:

If we create a sliding scale based upon an investment’s tax treatment if it were held within a taxable account, we can create the following scale:

Asset Allocation between account types

When approaching the asset allocation decision, an investor should first begin by grouping all of the accumulated savings together as a single total portfolio.

Example:  If you have accumulated $25,000 in your RRSP, your partner has accumulated $25,000 in their RRSP, $20,000.00 in a joint taxable investment account and both have $15,000 in TFSA accounts, then all of these individual amounts should be combined as a single portfolio. The investor then should develop a portfolio design and asset allocation for the accumulated total of $100,000.00.

Once you have developed a plan for your asset allocation by asset category, then you can move to the next level of asset allocation – allocation by account type. By accumulating your savings in many different types of accounts, you have tremendous opportunities to minimize the taxation applied to your investment portfolio.

Because each investment account type has differing characteristics and features, you have the ability to minimize the taxation on the income generated by your investment portfolio and maximize the flexibility around your savings.

Example: Let’s assume that you have accumulated a total portfolio, as outlined above, and you have determined that your asset allocation by asset category will be 15% ($15,000.00) invested in Cash and Cash Equivalents; 60% ($60,000.00) invested in Fixed Income and 25% ($25,000.00) invested in Growth.  As a result, when you approach asset allocation by account type, you may decide to hold the $15,000.00 in Cash and Cash Equivalent investments and $5,000.00 of your Growth investments within the taxable investment account, the remaining $20,000.00 of Growth and $10,000.00 of Fixed Income investments within the TFSA accounts and the remaining $50,000.00 of Fixed Income investments within the RRSP accounts.

The above asset allocation by account type will minimize the income tax burden upon your investments and maximize your savings flexibility.

Remember: By approaching your portfolio’s asset allocation by the investment category first and account allocation second, you can take full advantage of the unique characteristics and benefits offered by each account type.

Note:  For additional discussion about account types with their unique characteristics and benefits, visit our section Classroom: Account Types.

Now let’s begin Step 7 …

So, now that you understand the two different levels of asset allocation, you are now ready to actually begin Step 7 of the portfolio design: Determining your Asset Allocation.

When determining your investment portfolio’s asset allocation, you really want to focus on creating an investment portfolio that satisfies Step 5 – Calculate your Required Average Annual Rate of Return, while staying true to Step 6 – Define your Investing Personality.

With this in mind, you should begin by assessing the current rates of returns for the basic asset categories (Cash and Cash Equivalents, Fixed Income and Growth).

Begin with the safest investments first – Cash Equivalents and Fixed Income investments. Start by making a list of the current yields or interest rates offered by money market mutual funds, Guaranteed Investment Certificates (GICs), Government Bonds, Corporate Bonds and preferred shares. This will give you an approximation of the kinds of investment returns available for the first two asset categories.

So if your survey has determined that Cash and Cash Equivalents currently generate an average annual rate of return equal to approximately 1.0% and Fixed Income generates approximately 5.25%, you can now compare these rates of returns with your required average annual rate of return to see if they are compatible.

Example: In the example outlined in Step 5: Calculating your Required Average Annual Rate of Return, we discussed a 30-year old investor that required an average annual rate of return equal to 4.79% to achieve the goal of accumulating $500,000.00 by the age of 65. For this individual, he/she will be able to achieve his/her financial goal by investing 100% of the accumulated savings in Fixed Income. He/she does not need to take on additional investment risk to achieve that financial goal.

In Step 5, we also determined that if this individual were 40 years old, with the same accumulated savings and financial goal of accumulating $500,000.00 by the time he/she reach 65 years of age, his/her required average annual rate of return would be 8.03%.

If Fixed Income investments are only offering an average annual rate of return of 5.0%, then it is obvious that this individual cannot reach his/her goal by investing all of his/her accumulated savings in Fixed Income. He/she will need to allocate a portion of his/her savings to be invested in Growth assets. But how much of your savings do you allocate to higher risk Growth assets?

Finding the right balance between Fixed Income and Growth investments

Finding the right balance between Fixed Income and Growth investments is always a balancing act. At the same time that you want to increase the potential annual rate of return generated by your investments, you also need to minimize your investment risks. Surprisingly, investors do not need to invest the majority of their accumulated savings in Growth assets to achieve a reasonable rate of return with an acceptable level of risk.

This observation is supported by data collected by Russell Investments here in Canada and for the United States. For the specific details discussing the balance between asset allocations, rates of returns and volatility, see our section Single Asset vs. Multi-Asset Portfolios.

If we continue with our 40-year old investor, he/she accepts that they will not be able to earn their required average annual rate of return of 8.03% simply by investing all of his/her accumulated savings in Fixed Income investments. As a result, he/she must look at allocating a portion of the investment portfolio to an investment in Growth investments.

If we accept Russell Investments data that demonstrates that Large Capitalized Stocks have earned an average annualized rate of return of 11.80% over the past 34 years, from 1976 to 2010, then we have a gauge by which to estimate the expected return for Growth investments.

Note: Obviously, the 11.80% rate of return is historic and by no means guarantees future investment returns, but for establishing an asset allocation process, short of throwing darts at a newspaper, we can use this historical rate as our guide to establish our asset allocation process.

So our 40-year-old can begin estimating his/her asset allocation and average annual rate of return by using 5.25% for Fixed Income and 11.80% for Growth investments. Now our 40-year-old begins assuming various asset allocations for his/her investment portfolio and calculates the corresponding expected average annual rate of return for portfolios with various asset allocations. For example, he/she can begin by calculating the expected average annual return for portfolios with increasing allocations to Growth investments until he/she determines an asset allocation that is estimated to achieve his/her required return of 8.03%.

• An asset allocation of 90% Fixed Income and 10% Growth will have an estimated average annual rate of return of 5.91%. (e.g. Calculated as 0.90 X 5.25% = 4.725% plus 0.10 X 11.80% = 1.18%

• An asset allocation of 85% Fixed Income and 15% Growth will have an estimated average annual rate of return of 6.233%. (e.g.  Calculated as 0.95 X 5.25% = 4.4625% plus 0.15 X 11.80% = 1.77%)

• An asset allocation of 80% Fixed Income and 20% Growth will have an estimated average annual rate of return of 6.56% (e.g. Calculated as 0.80 X 5.25% = 4.20% plus 0.20 X 11.80% = 2.36%)

• An asset allocation of 75% Fixed Income and 25% Growth will have an estimated average annual rate of return of 6.8875%. (e.g. Calculated as 0.75 X 5.25% = 3.9375% plus 0.25 X 11.80% = 2.95%)

• An asset allocation of 70% Fixed Income and 30% Growth will have an estimated average annual rate of return of 7.215%. (e.g. Calculated as 0.70 X 5.25% = 3.675% plus 0.10 X 11.80% = 3.54%)

• An asset allocation of 65% Fixed Income and 35% Growth will have an estimated average annual rate of return of 7.5425%. (e.g. Calculated as 0.65 X 5.25% = 3.4125% plus 0.35 X 11.80% = 4.13%)

• An asset allocation of 60% Fixed Income and 40% Growth will have an estimated average annual rate of return of 7.87% (e.g. Calculated as 0.60 X 5.25% = 3.15% plus 0.40 X 11.80% = 4.72%)

• An asset allocation of 55% Fixed Income and 45% Growth will have an estimated average annual rate of return of 8.1975%. (e.g. Calculated as 0.55 X 5.25% = 2.8875% plus 0.45 X 11.80% = 5.31%)

From the calculations above, we can estimate that our 40-year old will need to allocate approximately 55% of his/her accumulated savings to Fixed Income investments and 45% to Growth investments if they are going to achieve their required average annual rate of return of 8.03%.

By calculating an estimate for the different asset allocations, you can estimate your asset allocation given your current savings, your ability accumulate regular savings, your financial goal’s Time Horizon, and the dollar value of your financial goal.

Remember: If the estimated required asset allocation makes you feel uneasy or apprehensive about the level of risk that you are required to assume to achieve your goal, then you should revisit your estimates of your ability to save, the goal’s Time Horizon, and the estimated final dollar value of the goal. You might find you can save more, take longer to achieve your goal, or decrease the goal’s dollar value. All of these would provide greater flexibility in establishing a more conservative asset allocation.

If you are looking at your estimated asset allocation and think it is too conservative, then you may want ask yourself why you want to expose your accumulated savings to greater investment risks than you need to achieve your required rate of return.

You are now ready to learn the differences between Single Asset vs. Multi-Asset Portfolios.

Proceed to Step 8: Determine your Diversification guidelines.