Portfolio Allocation Continued

Let’s finish our discussion about portfolio allocation. The all important 3 general rules about personal investing were explained in last week’s post: 1) always diversify your (risky) holdings, 2) recognize the importance of saving early and the subsequent power of compounding interest, and 3) understand the risk/return trade-off inherent in finance.

So how should you construct your portfolio – in other words, where should you put your money?
Firstly, most financial advisors would tell you that it’s crucial for every family to have an emergency fund, equal to between 3 - 6 months worth of living needs. This fund should be very liquid, meaning that it is very easily cashable and therefore instantly retrievable. Liquidity also implies a low level of risk. You can simply keep this money in the bank in a savings account, or you can also consider a money market fund. Money market funds act like mutual funds, but instead of investing in a variety of risky stocks, money market funds invest in mostly safe government debt and treasury bills that have short terms – i.e. 90 days, or even less. These funds can often give you higher returns than a savings account in a bank, but are not any riskier. All of the major banks offer money market funds – just walk in and ask them about it. The key questions to ask are: how liquid is the fund (i.e. if I need my money, how quickly can I get it)? Next, is there a fee for pulling out? And finally, what is the MER (management expense ratio)? The MER is a crucial statistic for any mutual fund – it’s what the fund managers will charge for managing your money. Some funds have an MER as high as 3% (i.e. they take 3% of your money every year, regardless of whether you gained or lost money during the year). Make sure that the average returns on the fund over the past few years exceed that MER. Believe me, don’t put it past the banks to charge you more money than you will earn.

If you cannot find a suitable money market fund, just keep the emergency stash in a savings account. Especially nowadays, when government debt is paying the lowest rates in history, it may not be worth the while to shop around for a money market fund. You can look for financial institutions that offer higher returns on their savings account; just remember, liquidity is the main objective here. Make sure before you sign away your money that you can easily retrieve your money without incurring penalties.

Okay, so you’ve set up and safely put away an emergency fund. What to do with the rest?
In the last post, I introduced the topic of risk. To re-iterate, the question of how risky you should be with your money is directly related to the question of “when do you need your money?” The sooner you need your money, the less risky with it you should be. If you are saving for a down payment on a house (within the next few years), I would highly recommend against allocating a large portion of your savings to stocks, unless you fully understand how the stock market works and also appreciate the risks involved. However, if you are young and saving for retirement – there is more room for riskier investments. I’d advise you to speak to a financial advisor before getting involved with stocks, or at least do your research beforehand.

Another factor is your personality - some people are far more conservative, and would rather see their money safely earning modest interest and growth. Others are more risky and can stomach variation within the markets. It's not easy - imagine investing all your savings in stocks, and then seeing 5% of it vanish in the first few months. If you're the type of person that will pull out in the short run (in the aforementioned situation), stocks may not be right for you. However, if you trust the markets and are willing to wait it out for long-term gains, then you more suited for riskier strategies.

Don't think personality is a 'soft' factor in portfolio allocation strategies - many theories in finance are based on the 'risk appetite' of the investor.

If you are looking for safer investments, try GICs (guaranteed investment certificates). GICs are simply basic cash investments that the bank holds on to for a certain time period and pays interest on the investment. The drawback is that GICs are usually not cashable for the duration of the term. GICs are offered by all banks, and they vary with term length and interest rates offered. Do shop around for different rates offered by the different financial institutions.
To note, default risk on GICs are practically zero. However, there is still a considerable amount of interest rate risk (see last week’s post), especially in today’s economic environment, as interest rates are expected to jump over the next few years. Since interest rates are expected to jump, if you are shopping for GICs, perhaps get shorter term GICs (i.e. 1 year versus 5 year), so that next year you can re-invest in a higher returning GIC, instead of being locked in at a lower rate for 5 years.

There are plenty of opinions and ideas out there about how an average portfolio should look - every financial situation is different, so do your research first or speak to a financial advisor. Nonetheless, i'll outline a typical retirement savings portfolio for a 35 year old:
70% stocks
20% bonds
10% cash and cash equivalents (treasuries, GIC's, etc.)

Within each allocation class, diversification is key. For example, the stock segment will contain stocks of different industries, dividend vs. growth stocks, etc. (these concepts will be explained next week). However, even amongst the allocation classes, many advisors would even advise to diversify further - perhaps in real estate, commodities (such as gold or silver), etc. For example:
65% stocks
15% bonds
5% precious metals/commodities
5% real estate
10% cash and cash equivalents

If you are looking to build a long-term portfolio with risk – remember to diversify. Next week, I will talk about how to enter the stock market safely and efficiently. The bond market is also a great place to invest your money, especially for more conservative investors, but the corporate bond market is arguably the hardest to understand (amongst the major allocation classes). Again, I’d recommend you referring to someone who knows their way around the bond and equity markets before you get involved.