The single most important thing an investor can do to achieve financial goals is to allocate investment assets wisely. Many Canadians planning for their financial futures find themselves spending sleepless nights worrying about which mutual fund to buy and sell, which stock to own, which one to dump; should they buy bonds now or should they put derivatives into their investment portfolio?
The type of investment planning this article will address is referred to as asset allocation. This means that as an investor, you allocate proportions of your liquid assets into different asset classes. In asset allocation your investments can be in one or a combination of these three categories:
1) Equities-ownership in companies;
2) Fixed Income-money invested in GICs, bonds, and mortgages or;
3) Cash-that is money invested in T-bills, chequing and savings accounts.
Studies have shown that asset allocation is the single greatest determinant of investment performance. It's been shown that approximately 80 per cent of the total-long term return of an investment portfolio is due to the asset allocation.
Unaware of this, many people blindly sink money into this or that investment without ever formulating an asset allocation model that is in sync with their financial goals and investment personality.
As a fee planner, I share with my clients as I share now with my students studying to become certified financial planners, that once you've determined your personal and financial goals and have formulated a plan to achieve these goals, it's wise to allocate your current and future investment assets in equities, f ixed income and cash. It's like keeping your money in separate pockets-but not in the same pair of pants.
All asset classes move in cycles. Each asset class has its own cycle. Typically, when one or two asset classes are performing well, the other asset classes may not be performing as well. By having a well defined asset allocation you are making your financial ride smoother.
Let's go through an example of asset allocation diversif ication and how this can work for the typical investor. Let's imagine a set of twins, Gwen and Joan. Both are 40 years of age.
Gwen invests $10,000 in a 7- per-cent bond which matures in 20 years. Joan also invests $10,000 for 20 years but separates the money into five, $2,000 investments. The first investment loses everything, the second earns nothing, the third earns 4 per cent, the fourth earns 7 per cent, and the fifth earns 15 per cent. At age 60, Gwen's investment has grown to $38,697 while Joan, who has practiced asset allocation, has grown her initial investment to $46,853.00. This is the true power of asset allocation.
Let's imagine you had put all of your liquid assets into technology stocks at the end of the bull market of the 1990s, like many people. Then in the middle of 2000, the very foundations of the technology sector in the stock market began to crumble, free falling into negative territory. You would now be hurting, and possibly both your life and your financial goals would be set back. With asset allocation it does not need to be this way.
Along with asset allocation, regular re-balancing of your portfolio is an essential element of long-term investment success. Rebalancing is a fundamental part of the process of reaching your financial goals in the most effective way while lessening the overall instability of your total investment portfolio.
An example of how effective re-balancing can be is illustrated in a study conducted by T. Rowe Price of Baltimore, Maryland, a top investment manager. What T. Rowe Price did was construct two $10,000 model portfolios made up of 60 per cent equity, 30 per cent fixed income and 10 per cent cash.
Using historical data spanning a 25-year period from the end of 1969 to September 1995, T. Rowe Price invested one portfolio using the original mix and never re-balanced at all.
The identical portfolio invested at the same time was re-balanced every three months to the original target allocation of 60 per cent equity, 30 per cent fixed income and 10 per cent cash.
At the end of the 25 year and nine-month period the re-balanced portfolio grew from $10,000 to about $145,000, the untouched portfolio grew to $141,000. By following a disciplined rebalancing asset allocation approach to investing, you are joining the ranks of the world's greatest investors by buying low and selling high. You do this by constantly trimming the asset classes which have done well and replenishing the asset classes that have decreased in value.
From time to time, as your life changes, and so do your financial and life goals, it is also important to re-evaluate your asset allocation mix.
What makes the asset allocation approach, the approach to long-term investing is it eases the turbulence that happens while investing and empowers you to stay the course to achieve your life and financial goals.
When it comes to achieving your life and f inancial goals, it should never be about market timing, it's about time and having the right asset allocation for you.