Do You Have the Right Asset Allocation?

In the midst of the meltdown yesterday, I got an email from my wife. Several of her work colleagues had been discussing the carnage in the markets and she was worried: our daughter will start university next year, and my wife wanted to make sure our RESPs would survive another crash.

The answer was yes, of course. Knowing that we’ll need about $15,000 this time next year, I’ve set aside that amount in cash. Another 60% of our daughter’s RESP is in bonds, with the duration carefully matched to our time horizon. The account has less than 15% in equities, which I will move to fixed income over the next couple of years. With that asset mix, even a 50% decline in the equity markets won’t jeopardize our investment plan one bit.

My RRSP, on the other hand, is 70% equities, so it has taken quite a hit over the past few months. I’m not thrilled about that, but since I don’t need the money for at least two decades, this latest market mess is nothing but a speed bump. In fact, I’m trying to scrape together some cash to take advantage of the fire sale.

I’m sharing this little anecdote because it’s a reminder that choosing an appropriate asset allocation is the most important investment decision you’ll ever make. Your portfolio’s overall mix of stocks and bonds not only has to match your comfort level with risk, but also the time horizon of your investment goal.

It’s natural to get spooked during a market crash. But if you’re panicking, if you’re genuinely concerned that your portfolio won’t recover before you need the money, or if you’re tempted to get out before things fall further, then you’ve got an inappropriate asset allocation. You need to reconsider your ability, need, and willingness to take risk.

No surprises

Market turmoil is inevitable: it’s happened before, and it will happen again, so there is no excuse for being blindsided. Anyone who invests in equities—and that includes broad-based index funds—should be prepared to lose half their money. Of course, you can expect to recover eventually, but after a 50% loss, your investment needs to double before you get back to even—and that can take several years of double-digit returns. If you don’t have that much time, then you need to keep most of your portfolio in safer investments, such as short-term bonds and cash. Yes, interest rates are low, but that is the price of safety.

In The Warren Buffet Way, Robert Hagstrom describes the great investor’s advice on this matter: “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.”

The road to financial ruin is paved with the bodies of investors who overestimated their ability to take risk. A properly designed investment plan—and a spouse who keeps tabs on you—will make sure you’re not one of them.

37 Responses to Do You Have the Right Asset Allocation?

  1. Tom August 9, 2011 at 11:59 am #

    As a newbie to the couch potato strategy, and to investing, it’s great to have such clear explanation of the importance of asset allocation. Thanks!

    If you pull together some cash, what will you choose to buy as part of this “fire sale”?

  2. Canadian Couch Potato August 9, 2011 at 12:03 pm #

    @Tom: Thanks, and glad this helps. I should stress that I’m not making any forecasts about what might go up, or when. I just mean that the equity portion of my RRSP is off-target, so this is a good to time to add new money to get it balanced again.

  3. Tom August 9, 2011 at 12:08 pm #

    Ah, I see. So you add new money to bring the percentage of equity in your RRSP closer to the number you decided on previously?

  4. Canadian Couch Potato August 9, 2011 at 12:12 pm #

    @Tom: Yes, I like to rebalance by adding money to what’s lowest, thereby avoiding selling anything if that’s possible. This is called “rebalancing with cash inflows.” See point number 3 in this post for more details:
    http://canadiancouchpotato.com/2011/02/24/how-often-should-you-rebalance/

  5. Mike Holman August 9, 2011 at 12:19 pm #

    Haha. I love the comment “and a spouse who keeps tabs on you”.

    Very true. Sometimes it’s good to have a second opinion (who owns half the $$) to prevent risky decisions or deviating from the investment plan.

  6. Jon Evan August 9, 2011 at 3:07 pm #

    I misunderstand. Do you not then subscribe to Scott Burns classic couch potato passive investing strategy: rebalancing anytime (passively monthly, annually etc.) meaning: adding new money irrespective of market conditions? I thought that passive investors didn’t need to follow the market but instead follow a time tested strategy of adhering to a asset allocation/diversification strategy and regular rebalancing just buying the market irrespective of valuation timing? Not following the wild fluctuations but instead quietly following a plan I thought makes the couch potato method so stress free and allows one to just forget about things happening around and go fishing! But yet, I see you are following the market and indeed looking for “fire sales” and that “this is a good time” to add money! It sounds a bit like market timing and valuation informed investing? Now I’m confused.

  7. Canadian Couch Potato August 9, 2011 at 3:22 pm #

    @Jon: Rebalancing is not market timing. If my strategic target calls for 70% equities and that allocation has fallen to 65% in this crash, then adding money to get back to 70% is precisely what the strategy calls for.

    If I were a market timer, I would overweight one asset class or another based on my market outlook. I have no market outlook, other than believing that asset prices are likely to revert to the mean over the long term. In that way, asset-allocation strategies have a built-in mechanism for taking valuations into account.

  8. Patrick August 9, 2011 at 3:38 pm #

    “Knowing that we’ll need about $15,000 this time next year, I’ve set aside that amount in cash.”

    This is the kind of common sense that most people discover only in hindsight. Congratulations on understanding the relationship between saving and investing.

  9. Canadian Couch Potato August 9, 2011 at 3:47 pm #

    @Patrick: Thanks for the comment. I think setting aside cash is hard for a lot of people these days because interest rates are so low. I’m making 1.2% on the cash, which is less than inflation. But I know with 100% certainty that it will be there when I need it.

  10. Jon Evan August 9, 2011 at 9:59 pm #

    @CCP Thanks for the reply!
    Yes, I understand asset allocation and rebalancing. I understand that you need to add money to get back to your strategic target allocation.

    I don’t understand the purpose for couch potatoes to check the market each morning because it should not matter what the market is doing since you are confident long term because of your asset allocation as you say. It should not matter that “this is a good to time to add new money to get it balanced again” because I thought passive investing strategy simply followed an abstract investing plan which called for “going fishing” ignoring the market but just rebalancing whenever money came available irrespective of what the market is doing and putting money in to keep one’s strategic allocation true to what one’s risk was calculated? Am I missing something :)? Is the “fire sale” just good luck or are you looking each morning for the right time to add more money?

  11. The Dividend Ninja August 9, 2011 at 11:23 pm #

    Dan, nice post 😉 I think many investors were caught off guard this week, this will be a good reminder for them about hte merits of “bonds” and “asset allocation.” Nobody likes to see their equities fall in value, but I have no problem sleeping at night with the portfolio I have, because it employs asset allocation with bonds, and income from dividends (sorry not the “D” word on the potato site).

    You are absolutely right, so many people feel they can handle risk until it hits them square in the eyes. You only have to go through a couple of those market cycles to know. Its too bad so many people are in over-priced mutual funds, when a Couch Potato portfolio with proper asset allocation would serve them so much better. We did the same with my partner’s RESP since the young one will be in college soon – all GIC’s for safety.

    Jon Evan, I think your just trying to split hairs and find some magic fault with potatoes. Who wouldn’t take advantage of opportunity when prices are down? Couch potatoes do it buy rebalancing to their target percentages, dividend investors buy great companies on sale etc. I think it’s a no brainer. Are you looking for Dan to make some outrageous confession he has a “secret dividend portfolio?” or something.

    Cheers

  12. J from Ottawa August 10, 2011 at 8:17 am #

    All of your model portfolios recomend 40% in bonds, how did you come to decide that 30%is the right alloication for you?

  13. Canadian Couch Potato August 10, 2011 at 9:29 am #

    @Ninja: You weren’t supposed to tell anyone about my secret dividend portfolio.

    @J: The 60/40 allocation is the usual standard for a balanced portfolio, but I note at the top of the Model Portfolios page that it can be adjusted up or down according to personal goals and risk tolerance. With my time horizon, I am quite comfortable with the volatility of a 70% equity portfolio in my RRSP. I use the Global Couch Potato for my kids’ RESPs, too, but with a much higher allocation to bonds.

  14. Tom August 10, 2011 at 11:10 am #

    This may be the wrong spot for an unrelated newbie question, but I’ll throw it out there anyway:

    I’ve got some funds in an RRSP with Investors Group, and I want to get that money out to start using it with TD e-series and the couch potato strategy. Is it possible to transfer money from one RRSP at one financial institution to another, without having to pay taxes on it?

  15. Tom August 10, 2011 at 11:22 am #

    Sorry, should have done my own research before asking that. I’ve just learned about the T2033 transfer, which appears will allow me to do what I want.

  16. Canadian Couch Potato August 10, 2011 at 12:25 pm #

    @Tom: Yes, as you’ve discovered, you can easily transfer funds from one RRSP account to another. In your case, the difficulty will be ensuring that you don’t get gouged with deferred sales charges when you sell your mutual funds at IG. Make sure you ask for disclosure of these fees you make the move.

  17. Tom August 10, 2011 at 1:00 pm #

    Thanks for the warning! If fees are high, should I just leave the money there and start fresh with TD e-series? I don’t really want to keep paying high MER on those funds, so even if the fees are high, wouldn’t it be better in the long run to make the move?

  18. Canadian Couch Potato August 10, 2011 at 8:22 pm #

    @Tom: It’s impossible to answer that question without knowing the details. Basically it comes down to calculating how long it would take you to break even. For example, if you figure you’ll save $200 a year on MERs but it would cost you $1,000 in fees to switch, then you have to ask whether it’s worth it. How long have you had the funds with IG?

  19. J from Ottawa August 10, 2011 at 9:36 pm #

    @Tom

    I faced a simalar problem last February when I decided to make the switch from funds to a couch potato portfolio, I decided to take the hit on the one time fees to withdraw (aprox 4,000 dollars in fees) as it did not make sense to me that I cointinue with underperforming funds, I would have had to wait two years to avoid the fees. I decided to track the old poportfolio to see if I would make up the difference within two years.

    It has only been 5 months and I have already made it up, this is mostly due to the fact that my advisor had put almost nothing in bonds and the equity market has declined, and the funds I was in have decined much more that the equity ETF”s.

    Had equities performed better this may not have happened so quickly but at this point I have no regrets. I would say your decision should be based on how long you have to wait to avoid the fees and how badly are your currents funds performing compoared to their indexes.

    That’s two cents of advice from another novice so you can take it where it comes from..

  20. Maxwell C. August 11, 2011 at 12:01 am #

    I always enjoy reading Jon Evan’s comments on here. He seems to be playing an excellent devil’s advocate, though I admittedly wonder why he bothers to follow this blog at all, given his presented point of view on investing ;-P.

    I’m sure that either way he’ll end up a committed Couch Potato investor after a few years though!

  21. Tom August 11, 2011 at 11:19 am #

    @J from Ottawa:

    Thanks for the input, J. I have held these funds for four years, so I guess it’s possible I may not face any fees. I’m not going to find out until I have everything set up with TD, because I only want to have the conversation once with my current advisor.

  22. Canadian Couch Potato August 11, 2011 at 11:23 am #

    @Tom: Typically deferred sales charges apply for six or seven years, although they decline every year, so by now they may be fairly small. One more suggestion: ask TD if they will reimburse you for the transfer fee that IG will charge (usually around $150). If your account is large enough, they may be willing to do this. Good luck!

  23. Tom August 11, 2011 at 12:17 pm #

    Thanks, Couch Potato! My account is pretty small, so I doubt they’ll pay the fee. Never hurts to ask, though.

  24. The Dividend Ninja August 11, 2011 at 8:56 pm #

    @Tom
    If it’s a TD Mutual Funds account, or a TD Basic RRRSP they likely won’t pay the fee (which is most likely what you are after). But if its a TD Waterhouse account they will credit back up to $150 of transfer fees – you just have to ask, regardless of account size. No gaurantees of course. But the problem is if you have less than 25K you will end up paying an annual $100 RRSP admin fee.

    IMO, getting away from the full service broker or Investors Group for that matter, is worth the initial cost. As you say if you held the mutual funds for a few years it shouldn’t be as painful – but they will find a way to get something out of you leaving 😉

    Cheers

  25. Patrick August 17, 2011 at 11:22 pm #

    @The Dividend Ninja and @Tom

    I can confirm that at least some TD branches will cover the transfer fees in order to get your future business even on amounts as small as ~$6000 for the regular TD mutual fund account (which was subsequently converted to an e-series account).

  26. Patrick August 18, 2011 at 10:53 pm #

    @Patrick: Impostor!

  27. Michael January 27, 2012 at 7:52 pm #

    Should cash be considered part of your asset allocation in a portfolio? I am referring to cash in the investment portfolio and not emergency fund or money required to pay the bills. For example, I may want to allocate 5% as a reserve for future investment opportunities.

  28. Canadian Couch Potato January 27, 2012 at 8:05 pm #

    @Michael: Yes, cash is traditionally considered part of a portfolio’ s asset allocation. Personally, I don’t include a cash component in any of my long-term portfolios because I believe it is likely to cause a drag on overall returns, but a 5% reserve is probably fine.

  29. mike June 20, 2012 at 10:39 pm #

    Do you have any recommended asset allocation rebalancing programs? I remember seeing some programs on some of the personal finance blogs. In fact I had bookmarked two for future use but my old computer crashed and I have lost all of my bookmarks. Thank you.

  30. Canadian Couch Potato June 21, 2012 at 10:07 am #

    @Mike: I created a rebalancing spreadsheet that you can download here:
    http://canadiancouchpotato.com/2011/03/03/how-to-lower-your-rebalancing-costs/

    Let me know if this helps.

  31. JP December 6, 2012 at 9:41 pm #

    I am following the Global Couch Potato model portfolio with TD e-Series mutual funds for my long term investments. However I would like something more short-term (3-5 years) for my TFSA account to save up for a house. I think I should have more fixed income fund because of the short time horizon, but the only option in the e-Series seem to be the TD Canadian Bond Index. I also really want to take advantage of the tax-free benefit of a TFSA account. Should I venture outside the e-Series and incur higher MER with funds such as TD Short Term Bond (TDB967, 1.11% MER) or TD Monthly Income (TDB622, 1.48% MER)? Right now, the money is just sitting in a high interest saving account. It seems like such a waste since it is earning interest at a rate less than inflation. Any couch potato advice for short term investment?

  32. Canadian Couch Potato December 6, 2012 at 9:57 pm #

    @JP: There really is only one place to put short-term savings for a major purchase: in a high-interest savings account. (Or GICs if you’re sure you won’t need the money before your target date.) I know yields are low, but that is the price of safety. Any other option exposes you to the risk of losing principal.

    Bond funds are not good short-term savings vehicles, since they have no maturity date.

  33. John December 3, 2014 at 10:45 pm #

    My current allocation is as follows:

    30% VCN – Non-Reg
    30% VUN – Non-Reg
    30% XEF – TFSA (not enough TFSA room so remaining in Non-Reg)
    10% ZDB – Non-Reg

    Come Jan 1 when I have another $5500 of TFSA contribution room, what should my strategy be in terms of allocation? I could have the full $5500 to contribute right away, but obviously I’m not going to put it all in XEF and screw with my allocation percentages.
    Would the best strategy be to simply put the $5500 into the 30/30/30/10 allocation and over the year I’ll eventually fill up the TFSA contribution room.

    Hope this makes sense. Also RRSP is not an option.
    Thanks!

  34. Canadian Couch Potato December 4, 2014 at 8:58 am #

    @John: It’s impossible to answer your question without knowing the amounts as well as the percentages. But you’re certainly right to but asset allocation before asset location. Since we’re talking about all equities here, the difference is not going to be very large.

    One thought: can you not simply move $5,500 worth of something to the TFSA from the non-registered account in 2015? That changes your asset location without changing your allocation at all.

  35. John December 4, 2014 at 10:01 am #

    @CCP:

    Amounts as follows:

    $57k VCN – Non-Reg
    $56k VUN – Non-Reg
    $41k XEF – TFSA
    $15k XEF – Non-Reg
    $18k ZDB – Non-Reg

    “One thought: can you not simply move $5,500 worth of something to the TFSA from the non-registered account in 2015?”

    How do you go about doing that? Just request the transfer from the brokerage (Questrade)?

    Thanks for your help!

  36. Canadian Couch Potato December 4, 2014 at 10:57 am #

    @John: It’s different at every brokerage, but all of them should allow you to transfer securities in-kind from one account to another. But if you’re at Questrade, where ETF purchases are free, it’s probably best to just sell $5,500 of XEF in the non-registered account, move that cash into the TFSA, and then repurchase it. It would only cost $5 for one trade.

    Make sure you understand the tax implications here. If you sell XEF you may realize a small capital gain. And If there’s a capital loss on XEF when you sell it, you would not be able to claim it if you immediately repurchase XEF in the TFSA (it would be a superficial loss).

    Hope this all makes sense.

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