Balanced investments show success

One of the first discussions we have with new clients relates to risk, which is often associated with equity investing.

Fixed income investments such as term deposits, guaranteed investment certificates and bonds are usually considered lower risk.

Most investors over the age of 40 should have a portion of their investments in fixed income as their time horizon is shorter.  However, the downside to having too much fixed income is the limited return potential in today’s market environment.  Cash and fixed income ensure capital preservation while the equity component provides increased growth potential.

The key to having “peace of mind” as an investor, is to have the appropriate balance that reflects your risk tolerance.  This balance is also known as your asset allocation.

Asset allocation classes include cash equivalents, fixed income, Canadian equities, US equities, International equities and real estate.  Let’s look at Jack Jones and the steps taken prior to choosing individuals investments.

Step 1 involves determining an asset allocation that best matches Jack’s risk and return expectations.  Here’s an example of his optimal asset allocation:

Cash Equivalents 5%

Fixed Income 30%

Equities – CDN 35%

Equities – US  10%

Equities – International 15%

Real Estate 5%

A person who is more conservative than Jack may want to increase the cash equivalents and fixed income component while decreasing equities.  What we find is that many do-it-yourself investors take an all or none approach to a specific asset class.  This means they may end up with either a 100 per cent equity portfolio or all of their money in GICs.   Portfolios that are 100 per cent invested in equities generally are more volatile, and hold greater risk of decline.  However, those who invest entirely in GICs may find it frustrating as yields are generally much lower.  In addition, for non-registered accounts interest income is fully taxable.  After tax is paid, it may be difficult for GIC investors to gain wealth after inflation is factored in.

Simply put, most investors should have a balanced portfolio that can weather different market cycles.

After the optimal percentages are determined above, Step 2 is to establish acceptable ranges as follows:

Cash Equivalents 0-10%

Fixed Income  25-35%

Equities – CDN 30-40%

Equities – US 5-15%

Equities – International 10-20%

Real Estate 0-10%

In a bull market cycle investors may find that the equity component of their investments may increase above the optimal amount noted above.  If the value of the equity class exceeds the acceptable range then a disciplined investment approach should involve rebalancing to the optimal percentages in Step 1.

This rebalancing is Step 3.  Selling equities and adding to fixed income and cash equivalents essentially shifts a portion of your profits to a lower risk asset class.

We encourage investors to stick to their long-term plan.  As fixed income securities mature, we should replace those investments with other fixed income options.

What happens in a bear market cycle?  Investors may find that the fixed income component as a percentage of their total investments increases as equity markets decline.  As noted above a disciplined approach to investing involves rebalancing.  It is possible that this process may involve allocating some of the proceeds from matured fixed income to purchasing equities.  This would only occur if equity markets have declined significantly.

Periodic rebalancing creates the discipline to sell a portion of your equity investments when times are good.  The cash equivalents and fixed income components should also be viewed as a potential source to purchase equity investments when the opportunity arises.