Build a better portfolio

In a recent workshop, participants were asked to recommend an asset mix for the portfolio of a 60-year-old couple. The suggested allocation for equities varied from 30 per cent to 85 per cent.Why such a range of recommendations?Building a sound portfolio depends on an understanding of basic investment principles and investment data—along with a good dash of common sense.

You must also take stock of your personal situation:

  • What are your investment objectives?
  • How much money will you need?
  • When will you need it?

Right for you
Determining your asset mix – how much to hold in cash, fixed-income and equity investments – is crucial to achieving your goals.

In fact, selecting individual securities before designing your asset mix would be like selecting furniture for your new home without knowing the floor layout. You could end up with pieces that don’t fit.

With too much in equities, your portfolio may not survive market turmoil. Go too heavy on fixed income, and your purchasing power could be eroded over time.

Figuring it out</strng
Any investment falls into one of three basic categories:

  • Cash
  • Fixed income
  • Equity

How much you hold in each category depends on many factors, including:

  • The size of your portfolio
  • The amount of income you expect to receive from other sources on a regular basis
  • Your goals for the money
  • Any other considerations important to you.

Analyse each category
If you consider some basis questions for each category, you can assess what mix of assets would work for you. For example:

With interest rates paid by some financial institutions hovering around 2.5 per cent, cash has taken a beating lately. Still, as an asset class, cash is important for the liquidity it offers. After all, what’s the point of having money if you can’t get at it?

You’ve probably heard you should have the equivalent of three to six months of income in emergency cash. But this advice is directed primarily at people who depend on employment income to pay regular bills.

When you’re retired, how much emergency cash you need depends largely on what portion of your expenses is covered by guaranteed sources of income.

For instance, if the income you receive from the Canada Pension Plan, Old Age Security, annuities or a company pension plan covers most of your bills, you can hold less cash in your portfolio than someone who needs to generate the bulk of their retirement income from an investment portfolio.

Since the stock market doesn’t care when you need the money, many people feel comfortable having enough cash available or coming in over the next 12 months to pay all their bills for the year.

Some people will also want a certain amount of “mad money,” cash to be spent on anything they desire. For some, this may be a few thousand dollars; for others, it may be substantially more.

Next page: Fixed income

Fixed income: 
In today’s low-interest rate environment, fixed-income investments tend to be downplayed. But they are important, especially for retirees. As part of a well-diversified portfolio, fixed-income investments can help ensure:

  • Cash flow that meets your income needs, either through regular income payments or maturing investments.
  • Capital preservation to generate sufficient income in the future – a consideration we tend to neglect, especially when equity markets are strong.

Why do people put money into the stock market? Because they believe investment in good companies will be rewarded with higher, tax-effective returns. They are willing to take some increased risk in exchange for potentially higher returns.

But how much of your asset mix should be held in equities? That depends on many factors, including:

  • How much of your required income comes from guaranteed sources
  • Your life expectancy
  • How much your portfolio must earn to fulfill your required income
  • How much investment risk you are prepared to take

Another measure is the sleep test. Simply put, you’re holding too much equity in your portfolio if you’re up at night with worry or if it puts you in a position of having to sell some of your investments when the market is down.

Just as you should not over-concentrate your portfolio in any individual stock, you should not focus on a single asset class.

Reduce your risk
To illustrate the importance of diversification, consider a sample portfolio with just two asset classes: fixed income and equity in a 50/50 mix.

In the first scenario, assume you can earn four per cent a year (after fees) by selecting good fixed-income investments and seven per cent (after fees) by selecting good equity investments.

Asset classAssumed returnPortfolio allocationContribution to annual return
Fixed income4 per cent50 per cent2 per cent (4 x 0.5%)
Equity7 per cent50 per cent3.5 per cent (7 x 0.5%)
Annual return from portfolio   5.5 per cent

After one year, this portfolio might return 5.5 per cent, with two per cent coming from the fixed-income investments and 3.5 per cent from the equity investments.

Next page: Diversify for safety

Diversify for safety
But let’s consider another scenario — a year when you again earn four per cent a year on your fixed-income investments, but end up with a loss of seven per cent on your equity investments (both after fees).

Asset classAssumed returnPortfolio allocation Contribution to annual return
Fixed income4 per cent50 per cent2 per cent (4 x 0.5%)
Equity-7 per cent50 per cent-3.5 per cent (-7 x 0.5%)
Annual return from portfolio   -1.5 per cent

In this year, this portfolio would have lost 1.5 per cent. However, the loss would have been even greater if you had held more in equities.

What’s magic formula?
When it comes to your asset allocation, you may have heard the old rule of thumb — an investor should hold fixed-income investments in proportion to his or her age.

So the proper allocation of fixed income in the portfolio of a 70-year-old investor would be 70 per cent.

But today, people are living longer and tend to have larger investment portfolios. Your asset mix decisions should not be tied to a rule of thumb but to a sound investment process.

Be sure your portfolio is designed to pay you the income you need — in reality, not just in theory.

Some retirees feel they can’t access their money, even though their portfolio is sound and performing well. For example, their bond interest and the dividends continue to be reinvested in their account rather than being paid out on a regular basis.

There’s a difference for many people between having money in their portfolio and having money to spend. After all, what’s money for?

Sandra Foster is the best-selling author of: You Can’t Take It With You and The Common-Sense Guide to Estate Planning (John Wiley, 2000).