What’s your portfolio’s ideal asset mix?

As the year winds down and markets flirt with new highs, it’s a good time to review your portfolio and make sure its asset allocation is suitable for your needs.

Investment_StrategyMost investors know that the main determining factor in how much your portfolio returns each year is how you proportion it among cash, fixed-income securities and equities. Typically your choice of asset mix is responsible for up to 90 per cent of the total return you make. Security selection, market timing and luck together account for the other 10 per cent.

Some investors don’t like to vary their portfolio asset mix. They may, for example, stay at five-per-cent cash, 45-per-cent fixed-income securities and 50-per-cent equities year after year after year, through good times and bad. Many of these investors argue that it’s foolish to try to guess which asset classes will do better or poorer in any given year, and so they just set a standard mix that will do well for them over many years. Thus the only time they make adjustments is to snap the asset mix back to the standard one, after it has ‘drifted’ too far off on its own. Also known as strategic asset allocation, this approach is often likened to a buy and hold strategy, or a ‘passive’ approach to investing.

Tactical asset allocation

Other investors believe that value can be added to your total return by shifting a portfolio asset mix to take advantage of expected market conditions. The term for proponents of this approach is ‘active’ investors, as opposed to the passive investors described above. Another term applied to the active approach is tactical asset allocation.

In the debate over which is the correct approach, we tend not to come firmly down on either side. For one thing, strategic asset allocation is not necessarily as static as it sounds. You may, of course, need to change your asset weightings due to changes in your personal situation, including a shortening of your investment time horizon, or the many unexpected accidents or occurrences that cause you to change your plans.

As for tactical asset allocation, it might sound like the ideal investment approach. But it can be akin to market timing if you’re constantly resetting your portfolio according to whether you think stocks will do better than bonds from one moment to the next or vice versa.

If you do want to practice tactical asset allocation, you’ll probably be better off changing your asset mix gradually and by small increments according to changes in the business cycle. Keep in mind that the tactical asset allocation approach typically keeps changes in your asset mix within limited ranges that conform to your investment profile. For example, a ‘balanced’ investor who seeks a balance between long-term capital growth and income might choose to keep equities somewhere between 40 to 60 per cent of her portfolio depending on market conditions.

A third way to arrive at a suitable asset allocation is one we’ve often suggested in this advisory. Simply take the time to sit down and figure out your future cash needs for at least the next five years. With money you’ll need in this time frame, make sure it’s protected from the unpredictable volatility of stocks. Be sure to invest it in highly predictable investments that let you know exactly how much you’ll make from them in the next five years, such as fixed-income securities and cash.

With money you don’t need in the next five years, consider placing it in equities. This will give you a rough idea of what asset allocation might suit you. From there you can fine tune it to meet your needs.

Formulas for asset allocation

Many financial planners suggest using your age to balance your assets. For example, they used to advise a 40-year-old to put 40 per cent of his portfolio in fixed income and 60 per cent in equities. For a 60-year-old, put 60 per cent in fixed income, and so on.

But with the decline in interest rates over the decades, this advice has been modified to enhance returns by investing more in the stock market. For example, instead of using 100 as the starting point in calculating your asset allocation, as in the situations above (100 – 40 years old = 60% in equities), start with 120 (120 – 40 years old = 80% in equities).

As we said above, however, we suggest you look at your future cash-flow requirements and use fixed-income securities such as bonds, stripped coupons and GICs to prepare for those needs.

When you have many years to retirement, our suggested approach will usually result in much less of your portfolio in fixed-income securities. But remarkably, as you approach retirement, you should get a result that’s similar to the age methods we comment on above.

This is an edited version of an article that was originally published for subscribers in the November 17, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

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