Index Investing

Index Investing

Part 8: Asset Allocation and Risk Tolerance

In the last part we discussed asset classes – and the indexes that represent them. Index funds are offered from different providers (as mutual funds or exchange-traded funds) that track those different indexes for small fees. These index funds will then become the building blocks of your portfolio. One big decision is how much of each to invest in – this is your asset allocation. How much of your money you are going to allocate (put into) each asset class.

Risk Tolerance is the Driver

The biggest and most important deciding factor for your asset allocation is your risk tolerance. Both stocks and bonds can increase and decrease in price, but stocks typically do so by much more. Diversifying broadly with index funds can help reduce the risk from something specific to a single company, but indexes absolutely do rise and fall and crash from time to time, and as an investor you need to be prepared for that. That is the risk of investing, and it is inescapable.

If you’re not prepared to sit through the very painful and scary experience of seeing your investments – everything you’ve worked and saved for – decline in value by 50% or more, then you can’t put everything into equities. You will need something a little less volatile, like fixed income (bonds or money in GICs or a savings account).

Your risk tolerance depends on many factors, which boil down to your ability to take on risk, and your willingness to take on risk.

If you need the money from your investments in a handful of years (less than the number of fingers you can count those years on), then you may not have the ability to take on much risk. If you have a long time to wait for a crash to correct itself, or have backup plans where you wouldn’t need all of the money you have invested, then you may be able to take more risk and get more of your money invested for the long-term in equities.

Even if you have the ability to take on risk, you also need to consider your willingness when deciding how you will invest. If you know that you will lose sleep or sell in a panic if you see any losses greater than 20%, or are willing to live with less and save more if it means a more certain path, then you may not have the willingness to take on risk (even if you might not strictly define those attributes as a matter of “will” yourself and call them another aspect of ability).

You’ll need both ability and willingness on your side before putting too much of your money into riskier assets like equities.

Rules of Thumb

Speaking in generalities about risk tolerance is fine, but how does that translate into an asset allocation plan and a portfolio? That can be a little tricky, as your ability and willingness to accept risk are fairly qualitative, and there isn’t an exact way to measure how much of a loss you’re willing to tolerate and what percentage of your investments you can put into equities based on that, or a formula to turn your feelings into index funds.

Some rules of thumb may be helpful in getting you started in this highly inexact art. A good starting place is to think of your time horizon: if you have more time available before you need the money (e.g., until retirement), you can generally take on more risk. Since we’re generally talking about retirement, we can use an age-based rule-of-thumb formula: take your age, subtract 10, and that’s the percentage to keep in safer stuff like bonds, GICs, and savings accounts. Put the rest into equities. So if I’m 41, I’d subtract 10, and aim to put 31% of my portfolio in fixed income, and 69% in equities. Of course, I could round that off – there’s no precision here – to something a bit easier to manage. A 30-70 split would be essentially identical, and even a 25-75 or 40-60 split would be close enough.

But that’s just a starting point, a frame of reference for the rest of my risk tolerance assessment. If I feel like I have better than average ability and willingness to take on risk, I can slide the equity portion up. Or put more into fixed income if I feel that my risk tolerance is lower than average.

Risk tolerance questionnaires are common ways for firms to help determine what a suitable portfolio for a client might be. While they are a far from perfect, they’re an easy starting point, and you can quickly take one to help get an idea of what your portfolio should look like.

Asset Allocation Specifics and Home Country Bias

Once you’ve made the most important decision in your asset allocation, next is to decide how to split up your fixed income and equity components.

Fixed income is usually an easier decision – you may want to split between government bonds and corporate bonds, and most common bond index funds already do that, so you likely only need a single bond fund. If you want to fine-tune things, you can come up with your own split of different fixed income funds, as well as including GICs and savings accounts in the mix.

When it comes to your equity portion, you will likely want a split between Canadian, US, and international equities. Exactly how much of each is a bit of a debate. Just like using market capitalization to weight the indexes themselves, you can use it to decide how much to put into each component. The US stock market represents almost half of the world’s economy (remember many major multi-national corporations are traded on the US exchange, so it’s not just the size of the US economy that matters), while Canada’s is somewhere closer to 5%.

However, there are reasons to have a home country bias and include more Canadian equities in your portfolio than our position in the world economy might otherwise suggest. Those reasons include tax efficiency, and the volatility of foreign currencies on top of the volatility of stocks adding risk to a portfolio that’s too heavily weighted to foreign stocks.

Exactly how much home country bias to have is far from an exact science, but splitting things roughly equally is a decent rule of thumb: roughly 1/3 of your equity portion in Canadian stocks, 1/3 in US equities, and 1/3 in International equities, and many model portfolios that you find will look similar to this. You can have more or less of each if you like – anywhere from 10-50% for any one of those components could be reasonable. The key would be to stick with whatever decision you make on asset allocation and not try to become an active manager increasing and decreasing your allocation to try to out-perform the market.

Considering Other Assets

There’s also no right answer when it comes to considering how other assets in your life may affect your asset allocation decision. A big one is if you have a defined benefit pension. A pension is in a way a little like having more fixed income: it provides security so you can continue to meet some of your financial goals (retirement income) even if your other investments perform poorly. Having a defined benefit pension may then mean that you have a greater ability to take on more risk, and could use that as a reason to put more of the investments you directly control into equities.

However, it’s not exactly like having more fixed income: you won’t see that pension asset in your investment statement, so if the market declines you may still see big losses, and it can be hard to tell yourself that what’s in your investment account isn’t all of your long-term investments. So it may not help with your willingness to take on more risk. You also can’t rebalance a pension into more stocks after they go down, or sell part of it in an emergency.

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