Asset allocation is more art than science. There are no immutable laws to tell you what proportion of stocks and bonds should be in your portfolio. The best you can do is adopt rules of thumb. “Make your bond allocation equal to your age” is a popular one, as is “Don’t invest in equities if you will need the money within five years.” In the end, it comes down to a trade-off between risk and expected returns.
I found a lot of useful insights on asset allocation in Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan
His book is written for an American audience and most of the financial planning advice isn’t useful for Canadians. However, a large part of the book is devoted to asset allocation decisions, which should be based on “the ability, willingness and need to take risk.” Let’s break down these three factors.
The ability to take risk
Swedroe says your ability to take risk depends on your investment horizon and the stability of your income (or human capital). If you’re 25 years from tapping your savings, or if you’re a senior public servant, you can keep a large portion of your portfolio in stocks. If you’re three years from retirement, or if you’re a commissioned salesperson, you should hold a far greater proportion of fixed income investments.
Swedroe offers these guidelines when considering the right equity allocation for your investment horizon. You can increase or decrease these suggestions based on your income security:
| Your investment horizon (years) | Maximum equity allocation |
|---|---|
| 0–3 | 0% |
| 4 | 10% |
| 5 | 20% |
| 6 | 30% |
| 7 | 40% |
| 8 | 50% |
| 9 | 60% |
| 10 | 70% |
| 11–14 | 80% |
| 15–19 | 90% |
| 20+ | 100% |
The willingness to take risk
How likely are you to panic when your portfolio loses value, as it inevitably will? Is a 25% drop going to give you ulcers? The willingness to take risk depends on your psychological makeup. Advisors give their clients risk-tolerance surveys to measure this willingness, but these are only worth so much. Only real-life experience — and we just had a litmus test in 2008–09 — will determine how big a loss you can truly tolerate.
Here are Swedroe’s guidelines for determining a portfolio’s equity allocation based on the degree of loss you can accept without hurling yourself out the window:
| Maximum loss you'll tolerate | Maximum equity allocation |
|---|---|
| 5% | 20% |
| 10% | 30% |
| 15% | 40% |
| 20% | 50% |
| 25% | 60% |
| 30% | 70% |
| 35% | 80% |
| 40% | 90% |
| 50% | 100% |
The need to take risk
Finally, all investors should consider their need to take risk. If your financial plan suggests you’ll need a 7% annualized return for 20 years to retire comfortably, you’ll need a significant allocation to stocks. But if you’ve saved enough money to meet all of your financial goals, you might forgo all market risk. Swedroe tells the story of a couple in their 70s who had saved $13 million, only to lose $10 million by investing it all in tech stocks. The couple admitted that if their portfolio had doubled, it would have had no effect on their lifestyle or happiness. Why, then, did they put all that money at risk for no reason?
Swedroe doesn’t match specific asset allocations to target rates of return, which is smart, since no one can predict what the markets will give us in the future. However, Vanguard has published historical returns for several portfolio mixes going all the way back to 1926. Just remember that these historical returns may be lower going forward.
[Update: For an overview of expected returns and how to estimate them, see the 2019 white paper I co-wrote with my PWL Capital colleague Raymond Kerzérho.]
Burton and Malkiel suggest allocations in Elements of Investing that I think would be useful to readers here – you may want to post them. They are not as conservative as the “Make your bond allocation equal to your age” though they do provide a table of more aggressive allocations and one that is more conservative.
Also, in true “set it and forget it” fashion, as someone in mid to late 30s, my rule of thumb has been to choose an allocation target and stick with it for defined set period of time. For my retirement portfolio that time is 5 years. So, on an annual basis I rebalance to this target until I am 40. At 40, I will revisit my allocation and bump up the fixed income portion and then revisit at 45, etc… For my RESP, I have chosen every 2 years as my defined set period of time. Without establishing this rule, I would fiddle too much with the allocation percentage.
@Greg: Good idea. See pages 108 and 109 for their suggested allocations.
For the record, I think their suggestions are too aggressive, especially Ellis’s. He suggests 85% to 100% in stocks for people in their 40s, and up to 50% stocks beyond age 80. Ask some retirees how that would have worked out in 2008.
@Greg
Since you re-balance yearly I’m curious where you put your money for most of the year as you earn it.
I had a similar plan, but with the top savings account at 2% (Ally Canada) and money market funds being lower than that, it makes me wonder.
Recently I’ve made budget cuts so that I can trade more often to take advantage of the higher yields I’m already seeing in the market. With $4.95 trades at Quest Trade it wasn’t really much of a sacrifice (a couple World of Warcraft accounts and some beer :))
While I agree with the underlying principles, I find the allocation tables rather simplistic. Reality is much more nuanced. For example, someone may be one year from retirement (0% equity) and yet 20 years (100% equity) away from needing the 20th installment of yearly income.
@RMCH – My secret is that my employer has an RRSP match program and I use the retirement program they offer to hold on to my savings until I can transfer them and purchase my ETFs. Money is drawn directly from my pay and is put into mutual funds in a workplace retirement account. Because the MERs of these mutual funds are reasonable, I have no problems investing in them (that portfolio is split almost evenly between canadian fixed, canadian equity, US equity and Intl equity). Once per year I move these investments into cash and transfer my portion of the RRSP contribution to a discount brokerage where I invest in ETFs. For the portion of my workplace plan that I am not allowed to transfer, I have set that to automatically rebalance to my target allocations.
I only recently took control of my wife’s RRSP. We are using index mutual funds and dollar cost averaging. Not sure yet how I will rebalance that.
I believe Couch Potato recently had an article on using TD Balanced Index Fund (TDB965) to hold monthly contributions. You should check it out.
Basic question since you’ve made a big deal about risk and equities. “How do you define risk?”
@Michael I think you can define risk in this case as the likelihood of a significant decrease in portfolio value. The longer the funds are in the market, the less downside risk.
@Greg, you commented way back last November but how did you end up dividing up your assets between you and your spouse in RRSP and/or TFSA’s? We are thinking of holding 1 of each type of fund across all our accts (Cdn Equity, US Equity, Int’l, Equity, 2 types of Bonds) as opposed to duplicating the same funds in each of our RRSPs. How did you end up doing it?
@Adam – I would clarify that point a little by measuring it as the probability of losing total net dollars and then the severity would need to be accounted for as well. The reason I make this slight distinction is I don’t think portfolio value means much of anything in itself. Only net cash means something. Let’s consider a few alternatives:
1. Cash – risk is 100% because there’s a 100% probability that over any reasonable period of time you’ll lose money on it, this is in spite of the fact that the “portfolio” hasn’t lost value, at least not on paper the dollars in equal the dollars out but if you consider net dollars after inflation (in my opinion if you’re not accounting for inflation, fees, and taxes then you’re lying to yourself)
2. Bonds – since you’ve got the coupon plus the underlying value and the underlying value is ultimately destined to be the face value the face value in theory over time has a 100% chance of losing value due to inflation, net dollars. However, because the coupon is paying returns over the whole life of the bond it mitigates a portion of that risk. In other words if you looked solely at the underlying value (what I’d call the “portofolio value” assuming you aren’t reinvesting the interest) you are guaranteed to lose net value. However, when you consider total net dollars you are better off.
3. Equities – tons of people focus in equities on the current value, when really the current value doesn’t matter, what matters is the total net dollars when you sell. Portfolio value could be done and you could be up (due to dividends) and yes over time in equities it’s true that the longer you hold on average (not true for any particular stock but for the asset class) the longer you hold the more likely you’ll increase in value. Of course, this might only be true if you’ve accounted for fees, taxes, etc.
4. Permanent Insurance – of all investment classes this is the most middle of the road where timeframes are concerned. On the one hand your portfolio value is guaranteed to NEVER go down, on the other hand in cases of hyper inflation you could lose money, this risk also increases with extreme amounts of time (as you near death the premium to maintain a death benefit increases radically dropping your internal rate of return and increasing the inflation risk)
It’s important to recognize that when you look at these scenarios time risk is not measured the same across asset classes. The risk of holding cash increases with time. The risk to the underlying value of bonds increases with time but the risk overall stabilizes (because you’ve actually received the cashflow, which there was a certain margin of uncertainty on at purchase). The risk to equities decreases with time. The risk to permanent insurance increases slowly with time.
Hi, I would like to know how to handle equity allocation with my risk profile. If I want to use the Complete Couch Potato but instead having 40% in fixed income, I just want 20% of fixed income, what should I do with the equity percentage? Should I just keep the same ratio as they are so I get something similar to this?
26.67% Canadian equity
20% US equity
20% International equity
13.33% Canadian real estate
—
5% Real-return bonds
15% Canadian bonds
Or do I have to split it another way than keeping the ratio for the equity part?
Thank you in advance.
@Sebastien: Target allocations are not an exact science, so I would just round off the numbers, e.g. 23% each to Canada, US and international, plus 11% real estate.
Ok, so if I understand, real estate should not be accounted with the canadian equity when we divide equity in 3 equal parts for Canada, USA and international. Does small-cap equity must be included to the country equity before I divide by 3 or is it separate like real estate?
@Sebastien: Don’t make the process too complicated. There is no magic formula: just pick a reasonable target and stick to it over the long run.
Hi Dan
i believe you have already written about bond etfs and their rate sensitivity. Just can’t find the article. do you know where I can find it?
tanks,
André
@Andre: This is probably the one you’re looking for:
https://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/
Hi Dan,
My wife and I will have good pensions when we retire. So how much can risk can we take in our investments outside our pensions? it’s more than if we didn’t have pensions but I don’t know what asset allocations to target now, and say, 15, 10, and 5 years from retirement, and after retirement. Are there any guidelines available for that? Thanks
@Pat: It’s impossible to answer that questions without doing a thorough financial plan, but this may help frame the discussion:
https://canadiancouchpotato.com/2014/04/14/ask-the-spud-is-my-pension-like-a-bond/
trying to figure out what is best for me…I will be retiring in 7 yrs, didn’t save as much as I should have but I have a defined pension…have been following ETFs and couch potato investing for some time, but I need to do somethimg now to ensure I have a comfortable retirement
@Mark: You should ask a financial planner as every situation is different and what you’re asking is not a general question.
Couch Potato investing is for long term investors. When you’re near retirement, you have to adapt your investment strategy to your lifestyle, actual value of your portfolio, risk you want to take, life insurance you want to buy, etc. That can be different for everybody and needs much more informations to do the math.
General rule of thumbs, if you allow more allocation to equity, you should expect higher return on the long term and maybe that will help to reach your goal in time.
Here is a quick income tax calculator to get useful infos like marginal tax rate on income, capital gain and dividends so you can do some simulations by yourself: http://www.ufile.ca/tips-and-tools/income-tax-calculator
I also have a workbook that could help you decide how to allocate your money over TFSA, RRSP and non registered accounts. It should be fine for most people, but again, you have to check with your financial planner or advisor as there is no guarantee that the results are the best for your specific situation. Make sure you download it as some features are missing when used in directly in Google Docs or Google Drive: https://drive.google.com/open?id=0B6x4qQK9cyjheDNXY29SeEtSS3M
Good luck !
Not sure if this is the right place to ask, but I have been thinking more and more about risk and and fixed income percentage. I am in my mid-30s and have 10% bonds (aggressive), but if I look at the model portfolios, the 10 and 20 year annualized returns are essentially identical for the 40%, 25%, and 10% fixed income strategies. Is this an anomaly and it just so happens we are at a moment where they are equal? Or should I take this as a sign that perhaps having more risk in my asset allocation may not yield higher returns in the long run?
In my situation I am investing for both short and long term (essentially just have this as a sort of savings account outside emergency funds), but my question is more general: Is it worth the risk to have less fixed income? Where is the benefit?
thanks everyone!
@Martin: This should answer your (common) question:
https://canadiancouchpotato.com/2015/04/07/ask-the-spud-do-aggressive-portfolios-pay-off/
Martin: Having more equity should give you better results on the long run as they tend to deliver better returns. When the interest rates will go up, bonds will lose value and you should see a bigger difference between safe and risky portfolios.
Oops, my apologies! I didn’t realize it had already been answered in detail. Thanks for the link, and I’ll be a bit better with the search function next time!
Thanks for the guide, and the Q and A in the comments section has been just as useful!!!
Is it a bad time to invest in most ETFs right now?
Using the couch potato method, should I use this technique for my cash and RRSP account independently or combine the two?
What I mean is if I should do a couch potato plan for each account? Or should I view them as a whole, with the bond portion of my CP plan in the RRSP account and the equity fund portions in my cash account?
Any suggestions?
@Francis: This should help:
https://canadiancouchpotato.com/2012/03/12/ask-the-spud-investing-with-multiple-accounts/
Thanks!
I intend to open a RESP account ( can I open the RESP in a TFSA account?) with TD, set up a monthly, probably pre-authorized deposit of 200, to waive the maintenance fee, as you have mentioned in the piece.
Obviously these are volatile times, do you think it is the best time to dive into the world of MF or should I bid my time for when the market bottoms and then buy MF at cheap rates?
Secondly, I had this breakdown of a model portfolio pilled from an online forum in which the advice was given to invest 7.69% into TD Canadian Bond Index and 92.31% into TD Canadian index, TD US Index and TD International Index split 3 ways equally in which each year the portfolio is balanced so that the TD Canadian Bond Index is increased by 7.69%, it will eventually lead to 100% in TD Canadian bond index over a 13-year period. What do you think?
Or do you think I should just go for those Target education Fund by the big banks (eg RBC Target Education Fund 2035), which is still a form of MF but actively managed by a professional with the upside of having an above average MER.
@Dan: Great white paper on expected returns! Have you seen any calculations done where they compared 100% equity portfolio returns to a mix portfolio with bonds, say for example 90/10? Where the comparison showed that having at least a small portion of bonds actually helped produce higher returns for the portfolio over the long term by taking advantage of re-balancing when stocks crash and you use bonds to buy a bunch of stocks on sale?
Thanks, Roger
@Roger: Thanks for the comment. Any analysis like this would need to make a number of assumptions about the timing of rebalancing. It will also be very period-dependent: for example, during the long bull market in bonds since the mid-1980s, 50/50 portfolios often performed as well as all-equity portfolios simply because bonds and stocks delivered roughly equal returns overall. That, of course, is not true over most periods.
In general, the sweet spot seems to be about 80/20. By that I mean that a portfolio of 80% stocks and 20% bonds will usually deliver better risk-adjusted performance than 100% equities (usually a moderately lower return, but with significantly less volatility). And by the same token, a portfolio of 20% stocks and 80% bonds is often less volatile than an all-bond portfolio, and may also deliver higher returns (the “free lunch” of diversification).
Interestingly, this 80/20 idea was first identified by Harry Markowitz in the 1950s when he created Modern Portfolio Theory. He noticed that a “portfolio” that consisted of 80% in a relatively stable stock and 20% in a volatile stock was actually less risky than 100% in the stable stock, while also delivering higher returns.
That’s why I typically wouldn’t recommend a portfolio of 100% equities or 100% bonds, no matter how aggressive or conservative you are. The 20% counterweight can have a lot of value.
There are some people who are in the enviable position of maximizing their registered accounts and having taxable accounts, and for many of these people they will never deplete the taxable accounts. So in this situation is it reasonable to think of asset allocation and investment horizon beyond ones lifetime? If the taxable accounts will be going to the heirs, isn’t the time horizon much, much longer? If the estate is closed during a market peak then the estate will be “selling high” so more money for the heirs. If the estate is closed during a market downturn then the estate will have a smaller tax bill and the heirs will be “buying low” assuming they are able to reinvest at the time. Of course, this last assumption is a big one but could be quite likely depending on the size of the portfolio. For the very wealthy, isn’t their investment horizon potentially generations long?
@Dan too: The short answer to your question is yes, absolutely. The time horizon for investment is based on when the money is expected to be spent, not when the owner expects to pass away. So a person who plans to pass along a portion of their wealth to the next generation should be thinking about the time horizon of their heirs.
@Dan Hi Dan, I’ve been reading your site and so far I haven’t really seen you recommend a 100% equity portfolio. My wife and I have our TFSA’s maxed out, and we will not withdraw the money until we retire 25+ years into the future, we have other savings in case of emergency etc. We understand if there is a bad bear market, the thing you should absolutely never do is panic and sell; if we had some spare savings lying around during the downturn we’d probably choose to buy more stocks in a non-registered account to capitalize on the discount. I feel like we are good candidates for a 100% equity portfolio, but I’ve never seen you recommend/outline when this is a good idea, other than this page indicating having a 20+ year time horizon is a requirement, so I wanted to get your thoughts and see if there are any caveats (other than don’t panic and abandon your strategy in a bad market). Does 100% equity seem like the best move for us? And if so, would the model portfolio for 100% equity just be 100% VEQT/XEQT? Thanks for putting together such an incredible investing resource!
@Alex: Thanks for the comment. Few investors have the stomach (or the need) for an all-equity portfolio. Certainly anyone who has been investing only since 2009 has never been battle-tested and doesn’t really know how they would behave in a deep, prolonged bear market. An 80/20 split is likely to be a better risk-reward trade-off for most aggressive investors. But if someone was looking for an all-equity portfolio, then certainly VEQT or XEQT would be an excellent choice.