Is Your Portfolio Just a Pile of Parts?

Your Portflio is BrokenIs there difference between a diversified portfolio and a collection of investments? That’s an insightful question Chris Turnbull asks in his new book Your Portfolio is Broken: Who’s to Blame and How to Fix It.

Turnbull is a portfolio manager with The Index House, an Edmonton wealth management firm. In his self-published book (available from Amazon), Turnbull explains that when he worked as a broker he would “recommend stocks, bonds, mutual funds, preferred shares, structured products, term deposits, new issues, and other types of securities, according to client preferences.” Often the clients would make their own suggestions, and those would end up in the portfolio, too. By the time he decided to end his career as a broker, his clients “collectively held 185 different mutual funds plus hundreds of stocks, bonds, and other securities.”

In other words, his clients didn’t have diversified portfolios: they simply had collections of investments. Turnbull uses an apt metaphor: “If, over many years, you acquired all the parts you thought you needed to assemble a car and you piled them up in your garage, would it be a car? Or just a pile of car parts?”

Portfolios with a purpose

A diversified portfolio isn’t an ad hoc collection of investments: it’s designed and built to achieve a specific goal. For example, an investor might aim for long-term returns in the neighbourhood of 5% to 6%, with only a very small risk of losing more than 20% in any given year. Each asset in the portfolio should play a specific role: it should be there to increase the expected return or to lower the volatility. If it isn’t doing one of those two things, it should not be in the portfolio.

When you apply that rule, the number of assets you need in your portfolio shrinks dramatically. If you’re investing with index funds, it’s difficult to imagine a situation where you would need more than 10 asset classes in a portfolio. In fact, four to six funds will do at least 90% of the heavy lifting.

But how many people have such efficient portfolios? Certainly not clients of the investment salespeople I’ve encountered: their portfolios appear to be almost completely random. They’ll include a monthly income fund that holds the same stocks and bonds they own elsewhere. Plus there’s that sector fund that did well last year, and the specialty ETF that has a good yield. Oh, and a market-linked GIC that seemed like a good idea a couple of years ago. Top it all off with a sprinkling of individual stock picks from BNN, each one making up less than 1% of the portfolio so they’ll have no meaningful impact. It reminds me of a shopper who pushes a big cart around at Costco and just tosses in whatever looks interesting.

If your investments are a hodgepodge like this, it’s time for a different approach. Instead of collecting a pile of car parts, think about the car you want to build. How far do you need it to go? In other words, what is your required rate of return? How much time do you have to get there, and how fast are you willing to drive? (How much risk should you take?) And how much fuel are you putting in the tank? (What’s your savings rate?)

Only after answering those questions can you decide what components you needed to build a vehicle to those specifications.

23 Responses to Is Your Portfolio Just a Pile of Parts?

  1. Slydermv September 9, 2013 at 1:30 pm #

    So I’ve been following this blog for a while now, and have taken the plunge, getting out of expensive mutual fund and putting my long term investments into indexs following your sample portfolio’s. I just had one quick question. I have about 50% of my cash in GIC’s, non-redemable. So rather then investing in bond funds, I currently have everything in equities (Canadian, Amercian and international), along with a RIET. Basically, I’m using this GIC allocation to level out the risks with my equity investments. Am I missing the point here? In my next rebalance should I be investing in some bonds, or does it make sence to look at things this way?

  2. Canadian Couch Potato September 9, 2013 at 1:38 pm #

    @Slydermv: There’s nothing wrong with using GICs in place of short-term bonds. A bond fund has some advantages (liquidity, easier to add money, easier to rebalance, potential for capital gains of interest rates fall, diversification beyond five years, etc.), but GICs can often be a good substitute.

    Your GIC holdings should be carried out thoughtfully, however. A five-year ladder is usually the most effective portfolio strategy.

  3. Lake Superior John September 9, 2013 at 2:19 pm #

    You have once again provided your followers with the evidence! Well done. Thank you for all this pertinent info. How many brokers are saying or will be saying ” oh no, not again Dan.”
    Keep up this great forum.

  4. Brian September 9, 2013 at 5:41 pm #

    An investment portfolio is nothing more than a collection of investments that aim for a specific rate of return at a specific level of volatility. The overall goals must be realistic and each component must have a realistic goals. If one cannot define the targets for a component, then it should not be there OR it should be considered as speculation/gambling of money that you can afford to loose.

    I think most investors and advisors have lost sight of these targets.

    For instance, I think if you polled investors and advisors about the current expected 10 year annual rate of return of a 60/40 portfolio, they says it would be 8% because that’s been the historical norm. But the current facts are that 10 year duration bonds will return 2.9% and equities via dividends and earnings growth will return about 5 to 7%. So a more realistic target is 4% to 5% ARR.

    I think this could make a good article to create more awareness and set realistic expectations for investors so they can plan accordingly.

  5. Brickets September 9, 2013 at 6:05 pm #

    According to this post, wouldn’t this turn the whole idea of indexing upside down? I believe many agree that indexing has a purpose, to provide market level growth. However, indexing itself is a Costco cart with a little bit of the entire store. That being said, I still strongly agree with the writer, on the part that a portfolio needs to have a clear and defined goal. Yet how that’s achieved, whether its a cart of everything, or a few select stocks, does not really matter; unless of course you’re talking about optimizing your portfolio for taxes and whatnot.

  6. Canadian Couch Potato September 9, 2013 at 6:14 pm #

    @Brian: Not sure about individual investors, but I haven’t encountered any advisors who are using estimates of 8% for a balanced portfolio. I’m sure there are a few truly bad ones who might do that, but pretty much everyone understands that fixed income returns cannot match what they were over the last 30 years and assuming 10% for stocks is wildly optimistic.

    I have a section on setting realistic target rates of return in my Perfect Portfolio book. As you’ve done, we just use the yield-to-maturity on the DEX Universe index for bonds, and we use Shiller CAPE for stocks. All the these methods are flawed, but they’re the best we can do.

    http://canadiancouchpotato.com/2013/02/25/estimating-future-stock-returns/

  7. Canadian Couch Potato September 9, 2013 at 6:31 pm #

    @Brickets: While it’s true that index funds include a large number of individual stocks and bonds, this is simply an attempt to capture the returns of an entire asset class. Diversification across hundreds of stocks is necessary to minimize volatility, and accessing these via an index fund is more efficient than buying them individually. In this context, an index portfolio should not be thought of as a collection of thousands of individual stocks and bonds, but as a collection of four to 10 asset classes, each of which has a unique risk and return profile.

    That said, if an investor had a portfolio like this…

    – 30 Canadian stocks, equally weighted and diversified across sectors
    – 30 U.S. stocks, equally weighted and diversified across sectors
    – An ETF covering international equities (because individual overseas stocks are expensive to trade)
    – A ladder of individual bonds

    …I would be happy to acknowledge that is at least a well-designed portfolio. The key point here isn’t that you have to use index funds: it’s that the assets in the portfolio should be be part of a larger plan, not just stuff you bought because your advisor or your brother-in-law told you it was a good idea.

    I have never seen a portfolio that looks anything like that, by the way. I’m sure they exist somewhere, but they are rare.

  8. Brian September 9, 2013 at 8:41 pm #

    @CCP You must associate with more enlightened people than I do. 🙂

    I’ve yet to meet one person who knows and is realistic about their portfolio’s target rate of return. On the fixed income side people mistake the current yield as the expected rate of return and on the equity side, they usually just guess.

    Also, a few years back, an advisor told me to expect a 6% rate of return with a 35/65 portfolio. Knowing a lot but still less than I know now, I thought he was in the ball park.

  9. SterlingF September 10, 2013 at 10:42 am #

    @CCP and all
    I have a separate but related question. I’ve been speaking with an insurance broker and they told me about a permanent life insurance policy that has an investing side to it. My understanding is that you have to fund (pay into with monthly payments) the policy and that you over-fund it with the extra being invested. Doing this instead of putting into an RRSP you’d be contributing the same amount but when it comes to retirement you take out a loan from the bank with the policy as collateral; paid back to the bank on your death. So instead of paying 30% marginal tax rate on your RRSP withdrawals you only pay the interest on the loan for a large savings of tax.

    Does anyone have advice about this? Has anyone done it? It sounds like one of those “too goo to be true’s” but I don’t know the caveats. I was told that you can self direct what you’re invested in but I’m guessing the options are limited with high MER. But if you could select from any ETF and mimic the CouchPotato it could be a good thing.
    Thanks!

  10. Canadian Couch Potato September 10, 2013 at 10:53 am #

    @SterlingF: What you’re describing is a universal life policy. Permanent insurance is appropriate for some people, and life insurance can be a useful estate planning tool. There are also situations where it can make sense as a tax shelter for people who have maxed out their RRSPs and have a lot of money they know they won’t need in their lifetime. But the scenario the insurance agent is describing (create retirement income by borrowing from your policy!) is likely to be great for the insurance company and not so great for you. An insurance policy is not an alternative to an RRSP, and I’m skeptical of anyone who tries to position it that way to make a sale.

  11. SterlingF September 10, 2013 at 11:35 am #

    @CCP: My feeling is the same….that it would benefit them more than me. The broker is actually a good friend of mine so I trust that it wasn’t for a sale. He did say that it was for wealthy people. I’m not wealthy but I’m in a good situation so I was curious what other people thought. Thanks again!

  12. Hekyll September 10, 2013 at 2:11 pm #

    @SterlingF. Permanent insurance, as the name implies, insures you for your entire life. Strictly speaking, we only need life insurance until all our dependents are secure and our debts have been paid off which is why, dollar for dollar, Term insurance is always cheaper and usually the better option for most people.

    Yes, the investments grow tax free within the policy but you are completely restricted to the insurance company’s products. For example, you are restricted to the insurance company’s mutual funds which (surprise, surprise) usually have higher MERs. If the insurance company doesn’t offer a REIT then you’re out of luck. So, the tax-sheltered growth comes with a price tag.

    Where Permanent/Universal insurance is useful is as an estate and tax planning instrument — particularly if you are incorporated. When the corporation owns the policy, the premiums can be paid as a tax deductible expense and the proceeds of the policy can be paid out to the beneficiaries (as shareholders in the corproation) tax free through a capital account. It is a great way for the wealthy to pass on their estate and avoid taxes. Apparently the Federal gov’t looking to change the way these policies are being taxed so there may be some time pressure for people considering these policies.

    One last advantage is if you’re on the run from creditors. With the exception of deliberate fraud and evasion, all investments inside the policy are protected through insurance legislation and are beyond the reach of creditors who are trying to go after your estate.

    I’m not a financial adviser, insurance, estate, or tax expert so take everything I’ve written with a grain of salt. However, as you can see, whether or not permanent insurance is right for you can be a fairly complicated question. I do feel that if you haven’t maxed out all your tax sheltered savings and you are not earning an income well in excess of your needs, permanent insurance would not be appropriate.

  13. SterlingF September 10, 2013 at 2:43 pm #

    @Hekyll – It doesn’t sound like this is for me for now or in the future. Thanks.

  14. KISS September 10, 2013 at 7:51 pm #

    Another thoughtful article, thank you. I’ve dealt with quite a few advisors through the years. Not a single one, to my recollection, took a “diversified portfolio” approach to investing, as opposed to a “pile of parts” approach. Their need to move a product seemed inevitably to overwhelm the question of whether it was a product that your portfolio actually needed.

    To SterlingF, my in-laws purchased a universal life policy 15 yrs. ago. Their subsequent experience convinced me that this is a particularly toxic type of product. As already pointed out, you are restricted to the insurance company’s investment offerings. Far worse, the MERs charged were shockingly predatory — if memory serves, something like 3-4% for an S&P 500 index fund! Moreover, the fixed premium for payment of the life insurance part of the policy was withdrawn quarterly (or was it monthly? can’t remember), creating the effect in a down market opposite to that of dollar-cost-averaging: more units needed to be sold to raise the funds for the premium payment. An altogether very painful experience.

  15. Brian September 10, 2013 at 9:06 pm #

    @SterlingF et. al. If the financial crisis taught us anything, it is to remember when buying any insurance product that you take on the risk that the insurance company may go insolvent. This is not an insignificant risk when one looks history and at how much debt some insurance companies in Canada have. There is Assuris to help if the company goes insolvent but their are limits to what is protected.

    With something like a bond or stock index fund you diversify risk, with an insurance company product you concentrate risk to that one company.

  16. VinceM September 11, 2013 at 1:32 am #

    I was wondering if you were going to comment the HXT consolidation? Wondering what are your thoughts… on the subject.

  17. Canadian Couch Potato September 11, 2013 at 9:56 am #

    @Vincent: The consolidation should have virtually zero effect on retail investors. It was done to reduce the trading costs incurred by institutional investors, who are more likely to incur transaction costs on a per-share basis. (Before the consolidation, XIU was cheaper to transact.) Note also that a one-cent bid ask spread is lower (in percentage terms) on ETFs with a higher unit price, so that should help reduce costs for all investors.

  18. Andrew Coyne September 12, 2013 at 4:52 pm #

    My plan is to hold an equity ETF covering each of the four main geographic areas — Canada, US, EAFE, and emerging markets — with smaller holdings for value and small-cap ETFs in each. Likewise, an aggregate bond ETF, with smaller long and corporate bond (and maybe a hedged international bond) holdings. Plus ETFs for Canadian, US and foreign REITs. That gets me up to around 18 funds. Too many?

  19. Andrew Coyne September 12, 2013 at 4:54 pm #

    NB All low-fee, index ETFs, natch, all to buy and hold.

  20. Canadian Couch Potato September 12, 2013 at 5:56 pm #

    @Andrew: An 18-fund portfolio, in my opinion, is overly complex. Remember that the benefits of diversification have to be balanced against the practical cost of maintaining that portfolio. And some of the asset classes in your portfolio are likely going to have less than a 5% allocation, so they are not going to have any meaningful impact on lowering volatility.

    Have a look at my Uber-Tuber model portfolio. That’s about as complex as I would get.

  21. Prasanna September 21, 2013 at 5:51 pm #

    Hi Dan:
    Re-Balancing:
    Regarding different asset classes, CDN Equity, US Equity Dev Mkt Equity so on…I have a mix of holdings in USD and CDN in most asset classes. When calculating the dollar value of a particular asset class for re-balancing purposes, do you convert the USD holdings into CDN at a spot rate on that date or do you recommend to just take absolute amounts only. thanks very much
    Prasanna
    Maple,ON

  22. Canadian Couch Potato September 21, 2013 at 11:56 pm #

    @Prasanna: Before rebalancing your portfolio you should always convert any USD amounts into CAD.

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