Archive | Asset classes

How Much Risk Do You Need to Take?

Every book on index investing stresses the importance of asset allocation: the percentage of equities and fixed-income investments in a portfolio. Of course, more stocks means more risk but higher expected returns, while boring old bonds provide safety and promise less growth. But just what is the long-term difference in risk and returns between stocks and bonds? How does a 50-50 portfolio compare with one that holds just 20% bonds, or 20% equities?

Paul Merriman, who runs the Seattle-based investment firm that bears his name, recently wrote an article that included a table of historical stock and bond returns going back to 1970. It compares the performance and risk of portfolios with various stock-bond mixes. The returns are hypothetical, but they represent a reasonable estimate of what you might expect from a portfolio of low-cost index funds that track the broad markets.

Merriman assumes that the equity portion of each portfolio is split equally between the S&P 500 and international stocks, and the fixed income side is half intermediate-term, 30% short-term and 20% inflation-protected Treasuries. They also deduct a 1% management fee and assume the portfolio is rebalanced monthly. Here’s a summary of the results:

Annualized return
Standard deviation
Worst 12 months
Worst 60 months

100% fixed income
6.9%
4.6%
-4.8%
14.1%

10% equities
7.5%
4.6%
-5.3%
14.3%

20% equities
8.2%
5.1%
-11.6%
10.1%

30% equities
8.8%
5.9%
-17.5%
5.9%

40% equities
9.4%
6.9%
-23.1%
1.6%

50–50
9.9%
8.2%
-28.5%
-2.7%

60% equities
10.5%
9.5%
-33.5%
-7.0%

70% equities
11.0%
10.8%
-38.3%
-11.3%

80% equities
11.5%
12.2%
-42.8%
-15.5%

90% equities
11.9%
13.7%
-47.1%
-19.7%

100% equities
12.4%
15.1%
-51.1%
-23.9%

There are a couple of lessons in these numbers.

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Put Your Assets in Their Place

Couch Potato investors hear a lot about asset allocation, but asset location is also an important consideration. Asset location refers to the type of account you use to hold the stocks, bonds, cash and real estate in your portfolio. It’s important because the growth and income from your investments are treated in different ways by the taxman:

Interest from bond funds and bond ETFs (as well as individual bonds, GICs and money market funds) are taxed at your marginal tax rate, just like employment income.

Dividends from Canadian stocks are eligible for a generous dividend tax credit from the federal government. For the 2009 tax year, eligible dividends are first grossed up (increased) by 45% and declared as income; the investor then receives a tax credit of 19% on the grossed-up amount. Some provinces offer an additional dividend tax credit.

Foreign dividends are taxed at your marginal rate. In addition, many countries (including the US) levy a withholding tax on dividends, often between 10% and 15% (this may be recoverable in non-registered accounts).

Capital gains are profits earned from selling a security for more than you paid for it.

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The Ethical Couch Potato

Recently a reader wrote to me with an intriguing question: “I’m very interested in the Couch Potato strategy, but I have an added hitch: I’d also like to engage in socially responsible investing. I know there’s the iShares Jantzi Social Index Fund (XEN) for Canadian equities, but I’m not sure if there are other Canadian indexes out there, or what is available in terms of US, international, and emerging markets.”

For those who aren’t familiar with this idea, here’s a definition from the Social Investment Organization, a Canadian non-profit: “Socially responsible investment (SRI) is the inclusion of social, environmental and governance considerations into the management and selection of investments.” Companies commonly excluded from SRI indexes are those in the business of tobacco, weapons, and those with poor environmental performance, human rights violations, or poor employee relations.

Turns out that only one other index fund tracks the Jantzi Social Index, which is the most common SRI benchmark in Canada. The Meritas Jantzi Social Index Fund is one of seven socially responsible mutual funds run by a Winnipeg firm with close ties to the Mennonite community. It’s the only index fund in their lineup and it has a management expense ratio of 1.94% and a hefty front-end load or deferred sales charge.

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Bad Advice from BMO

Jim, a loyal reader of this blog, recently emailed to ask about the model ETF portfolios that BMO is offering to its InvestorLine clients. The portfolios were designed by Lipper, the mutual fund research firm based in New York. “All the Lipper Leader Model Portfolios,” BMO’s website explains, “are based on a proprietary Lipper rating and built by their independent and unbiased experts.”

I can’t link to these model portfolios, since they’re available only to InvestorLine clients, but Jim sent me some details. Here’s one for long-term investors looking for a balance of income and growth:

Equity

iShares Canadian LargeCap 60 Index (XIU)
19.1%

iShares Canadian Composite Index (XIC)
10.9%

PowerShares QQQ Trust, Series 1 (QQQQ)
9.7%

WisdomTree DEFA Fund (DWM)
8%

Fidelity NASDAQ Composite Index Tracking Stock (ONEQ)
5.3%

Fixed Income

iShares Barclays 7-10 Year Treasury Bond Fund (IEF)
20%

iShares Barclays Aggregate Bond Fund (AGG)
19.1%

iShares Barclays TIPS Bond Fund (TIP)
7.9%

Jim asked whether this portfolio might be appropriate for an RRSP. My answer is that this portfolio isn’t appropriate for anyone in Canada,

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Couch Potato Basics, Part 2: Pure Asset Allocation

This post is the second in a five-part series outlining the primary benefits of the Couch Potato strategy.

Most investors understand the importance of diversifying. By spreading your money across different asset classes—cash, bonds, stocks, real estate, commodities—you can lower your portfolio’s overall risk and boost your returns over the long term. In fact, your asset allocation is probably your single most important investment decision.

Unfortunately for investors buying actively managed mutual funds, getting that target asset mix is often extremely difficult.

Say you decide to split the equity portion of your portfolio equally among Canadian, US and international developed countries. For your domestic and US stocks, you choose the Trimark Canadian Series A and Trimark US Companies, respectively. You round things out with the Dynamic EAFE Value Class fund, because it trounced its benchmark in 2009. (That benchmark, the MSCI EAFE index, includes 16 developed countries in Europe, plus Australia, New Zealand, Japan, Hong Kong and Singapore.)

You might reasonably expect this would put about 33% of your money in each of the three regions. But you’d be wrong.

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