Asset mix should be tied to cash-flow needs and market conditions

The term asset mix refers to the portion of your investments that are held in cash, fixed income, and equities. Asset mix has historically been touted as the most important decision with respect to managing risk adjusted returns. We don’t disagree.

The key question that many people should be asking themselves is the portion of their portfolios that should be in these three categories. Every decade we feel investors have had to shift how they look at asset mix to maintain the best risk adjusted returns. This has largely been the result of declining interest rates.

Rather than rely on older textbook solutions to asset mix we feel clients should focus on cash flow needs and current market conditions. When we meet with clients, one of the first questions we ask them is if they need any cash from their portfolio. Essentially we are asking them the time horizon of a portfolio and whether they are planning to make a significant withdrawal of funds. In more than 90 per cent of times when we ask clients this question, the majority of the investment portfolio is to be invested for the long term (greater than seven years).

We also ask clients whether they have any income requirements from the portfolio, or smaller withdrawal requirements. Many of our retired clients will request that we send them monthly cash flow from their investments. If a client desires $5,000 per month from their portfolio then we would typically put aside 12 to 24 months of cash as a “wedge” earmarked for these smaller withdrawals. This is done to ensure that investments do not have to be sold at the wrong time in the market cycle.

We also ask clients if they will require any significant withdrawals from their portfolio in the next three years. Examples of significant withdrawals will be funds to repair home (i.e. roof), renovations, new vehicle, recreational (i.e. boat, motorhome) and real estate purchases. These amounts are also documented within an Investment Policy Statement and earmarked as part of the “wedge” to ensure the funds can be liquidated and sent when needed regardless of market conditions.

We feel cash flow needs and current market conditions should be the primary determinate for asset mix. To give you an example of older guidance often used with respect to asset mix we have outlined a few observations by decade below.

The 1980s

In the 1980s, interest rates were high and many advocated for retirees to transition portfolios to 100 per cent fixed income. This was during a period when bonds, GICs, CSBs, CPBs, and term deposits actually returned a decent level of interest income to live off. Purchasing annuities was a popular option as yields were significantly higher and translated to higher payouts. Financial plans which make long term assumptions based on 1980s high interest rates were materially over stated when interest rates subsequently declined in future decades.

The 1990s

In the 1990s, the strategy most promoted was to encourage investors to have the fixed income percentage equal to their age. The idea was that as you are aging your portfolio would shift into more conservative investments that paid income to you in retirement. Fixed income still generally had higher income than equities.

The 2000s

In the 2000s, many promoted the strategy of laddering your bonds and fixed income. A bond ladder means you have different bonds with varying maturity dates. This was a way of spreading out interest rate risk. As bonds matured in the ladder, you could use some of the capital if necessary and reinvest the remainder.

The 2010s

Bond laddering started to decline as interest rates started to bottom out. Most economists, and fixed-income bond managers, were recommending to keep the bond duration (term to maturity) shorter. The reason for this is the inverse relationship that bond yields have to the bonds actual price. For example, if interest rates go up, most existing bond prices would decline. The greater the duration of the bond, the greater the decline typically.

To deal with this uncertainty of interest rates, many hybrid type investments were created that had features (resets, call dates). Most of these types of investments lack significant volume and can have material price swings which was not typical of fixed income type investments.

The present and the 2020s

Fast forward to today and what we anticipate in the decade ahead. The following are the top ten bullet points we discuss with our clients:

1) Many chief investment officers and economists feel that central banks simply can’t afford to raise interest rates significantly above current levels. The level of government debt would only spiral out of control further. Interest rates are most likely to stay at low levels for a long time.

2) In Canada, we have raised interest rates five times since the historic lows reached in 2017. If the economy softens, the Bank of Canada is in a position to cut interest rates.

3) The term “fixed income” seems rather archaic when many fixed income rates can shift with many of the new fixed income products. The term step up and floating are just a couple of the terms using in fixed income today.

4) It is ironic that most equities have a higher level of dividend income then the interest yields on fixed income. If investors want high income they can typically achieve this with good quality dividend paying equities.

5) Most bonds pay “interest income,” which is fully taxable in non-registered accounts. Canadian equity investments pay tax efficient dividend income (eligible for the dividend tax credit). All equity investments in a non-registered account can provide deferral of unrealized gains and tax preferred treatment on disposition (only 50 per cent is taxed).

6) Bonds trade outside of an exchange and the price transparency is not as good as equities which trade on an exchange. With most bond purchases, the financial firm you are dealing with is acting as principal, rather than as agent. With a principal transaction, the firm will buy the bond off of the client and put it in their own inventory of bonds to either hold or resale.

7) Fixed income often lacks a high volume of transactions (i.e. preferred shares) and is also susceptible to material price fluctuations. Some fixed income lack liquidity (i.e. longer term GICs and term deposits).

8) Increased scrutiny by regulators of suitability of asset mix on investment portfolios. This creates a natural tendency to possibly be overly conservative unless a full discussion is done with your portfolio manager or wealth adviser. Importance of communicating cash flow needs (both short term income requirements and required significant withdrawals).

9) Conservative investors choosing to have asset mixes heavily weighted in fixed income should have lower return expectations for the next decade ahead. Interest rates will likely stay at low levels for a long time. With even a moderate level of inflation and full taxation on income, after tax returns will not be the same as the past several decades.

10)In order to achieve the best risk adjusted returns, investors will have to invest more heavily in equities than past decades. This means that investors will have to deal with more market volatility and stick to a disciplined plan. Our recommendation for retirees who are opting to increase equity components in their portfolio is to avoid high risk and speculative positions.

It is crucial when working with a portfolio manager or wealth adviser to map out cash flow needs and any significant withdrawals. It is only after that is completed that an appropriate asset mix can be set up and the best decisions can be made on where to draw on those cash flow needs.

Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.