Developing an Investment Plan
One of the first questions an investor must decide is how to divide his or her portfolio between stocks (equities), bonds, and cash. This division is known as "asset allocation", and will depend upon the investor's goals, age, current financial position, risk tolerance, what size estate he or she wants to leave, and other factors.
Because of the different tax treatment of dividends, capital gains, and bond interest income in Canada and the US, the distribution of assets between tax-exempt and non-registered plans recommended in American references is not appropriate for Canadians. Tax-effective asset distribution of assets for Canadians is discussed later in the section on cost control. Nevertheless, the link below, although aimed at US investors, covers many of the pertinent topics:
Vanguard, a low-cost U.S. investment company, also has a useful guide:
Another excellent on-line source that covers many investment subjects is Frank Armstrong's Internet book Investment Strategies for the 21st Century.
Defining your Goals
The initial step in developing an investment plan must be defining your goals. Are you investing for retirement income? If so, do you need income now? Do you wish to leave an estate? What is your time horizon? How big a dollar drop in your portfolio can you tolerate without losing sleep? Only you can answer those questions.
Your portfolio may well need its composition adjusted over time. As a general rule, the risk associated with a portfolio should be reduced as the portfolio approaches termination. If you are investing for a specific event - say, a college education for a child - your investment plan should envision switching the plan to low-risk assets as the child approaches 18 years of age. If you are planning to retire and live off your portfolio's income, you will probably need to increase the portion assigned to interest-producing or dividend-producing assets as you near retirement age.
One of the main questions that investors who are investing for retirement ask, is "How much do I need?" To obtain a rough answer in today's dollars (i.e. before inflation), perform the following calculation:
The resulting figure will be your investment target. If it seems unreachable with reasonable rates of return (say 4-6%, after inflation), you will have to adjust your goals.
The fundamental tradeoff all investors must face is that a higher return will be associated with higher risk. It is said that an investor can either eat well or sleep well - but not both.
What is Risk?
The mathematics that lies behind much of the development of modern mathematical theories equates risk with portfolio variability (as measured by a statistical property called the standard deviation1, or its square, the variance). Conceptually, risk is the chance that the money will not be there when you need it. Using the standard deviation as a risk measurement proxy makes the mathematics simpler.
In an important study called the "Brinson-Beebower Study" and later works including papers by Ibbotson and Kaplan, it has been shown that portfolio variation is principally determined by the asset allocation. Reduction of risk usually means reduction of the amount of high-risk assets in a portfolio.
To examine why asset allocation between high-risk and low-risk assets is so important, let us consider three separate portfolios, each initially $100000, with three different asset allocation targets:
Table 1. Initial Allocations of Three Different Portfolios
Let us then imagine that the low-risk assets increased by 20% in value over the same period that the high-risk assets decreased by 50%. This is approximately what occurred to bond and stock indexes (so far) over the 2000-2002 bear market:
Table 2. Final Allocations of Three Different Portfolios
The effect of including the low-risk asset class is to substantially reduce the effects of a drop in the value of the high-risk asset class. The greater the proportion of low-risk assets, the lower the effect of a major price drop in high-risk assets on the portfolio value. In this example, the low-risk assets actually increased in value when the high-risk assets decreased.
1. The standard deviation is related to the spread (width) of a set of different annual returns over a multi-year period when those returns are plotted on a graph showing probability versus return. The graph usually has the shape of the familiar "bell curve".
The Face of Risk
As was shown in Table 2, investors with a large portion of their portfolios in high-risk assets faced significant losses in the 2000-2002 bear market. These losses are not unprecedented, and are a direct consequence of holding a significant amount of the portfolio in high-risk assets. Investors who held a large portion of their assets in equities during the 1973-1974 bear market faced similar losses, as is shown in the following table excerpted from "The Four Pillars of Investing" by William Bernstein:
Table 3. Risk and Return for Various High Risk/Low Risk Portfoliosa,b
Although the losses in given in Table 3 for the 1973-1974 bear market are similar to those shown in Table 2,there is no guarantee that future returns - or future losses - will be similar to those in Table 3. Nevertheless, the data in Table 3 show how both the final return and the probability of loss increase with increasing allocation to stocks. When after-inflation returns are considered, the improvement in overall return with higher equity allocations is even more dramatic.
Instead of categorizing their investments by function as "equity" or "income", investors should categorize them by risk. Higher-risk assets include stocks, income trusts, real estate and real estate trusts (REITs), royalty trusts, and high-yield ("junk") bonds. Lower-risk assets include government bonds, high-quality corporate bonds, and high-quality preferred shares. These are shown in the following table, with suggested maximum allocation ranges:
Table 4. The Risk Tablea
As discussed below, risk can also be reduced by including several different asset classes in a portfolio.
In general, a higher return is associated with a greater amount of risk. Investors are said to be rewarded for the risk. As was shown in Table 3, equity (i.e. stock) portfolios usually produce a higher rate of return than do bond portfolios, but also have a higher standard deviation. That extra return is not guaranteed - stocks can, and do, go down - so risk-averse investors (most of us) should limit the amount of stocks (or high-risk assets) in a portfolio to less than 100%. Including a modest (25%) low-risk (bond) portion will reduce portfolio return only slightly while reducing volatility significantly. In general, from 25% to 75% of the portfolio should be in low-risk assets.
In the asset accumulation stage, portfolio risk is relatively unimportant (assuming the investor has a stable job and sufficient emergency funds), and return is all-important. During asset withdrawal in retirement, however, risk is of very high importance, since the money may not be there when you need it. As will be seen in the section on portfolio construction and evolution, the differing importance of risk means that portfolio construction will vary with the age of the investor.