Portfolio Design and Construction
In finance, a portfolio is a grouping of financial assets such as stocks, fixed income and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals. 
Before you create an investment portfolio, create a list of your financial assets and liabilities. In general, investing in stocks or fixed income (bonds are a subset of fixed income) should come after other financial needs are met: credit card debt is paid off; an emergency fund is established; sufficient insurance is in place, and so on. Some investors have both investment portfolios and house mortgages simultaneously; to some extent, this is a matter of personal taste and risk tolerance as well as a financial decision.
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Creating a Plan
A financial plan makes recommendations in a number of areas. Financial planning is not about amassing a pile of money. The initial and most important step is identifying objectives (in a family, agreeing on shared objectives), e.g. buying a house, retiring early, ensuring that children get an excellent education, and so on. Determining what the objectives are is primary. Since what usually requires money in the modern world, financial planning then proceeds methodically to lay out how.
An age and risk appropriate adequately diversified asset mix will help protect assets during severe market downturns. When one is 20, there's a entire working life to recover from a downturn but when one is near or in retirement, recovery is not likely possible.
What is age appropriate? There is a rule of thumb ("age in bonds") that says subtract your age from 100, where 100 is expected longevity, in order to obtain an equity/fixed income asset mix. A 20-year old would have an equity/fixed income asset mix of 100 - 20 = 80 or 80/20. A 60-year old would have an equity/fixed income asset mix of 100 - 60 = 40 or 40/60. This concept is best graphically represented by a human capital graph:
When you are 20, you have little financial wealth but an entire earning lifetime ahead of you. You can afford to have an aggressive asset allocation. You may not have the stomach for an aggressive allocation which is where tolerance for risk questionnaires come into play. As you age, your financial wealth increases but your earning lifetime decreases and your asset allocation becomes more conservative. Even if the tolerance for risk questionnaire says that you can take an aggressive asset allocation, you shouldn't. You need to protect your assets because you have no way of replacing them.
As with everything, there are always exceptions. If you have an indexed, defined benefit pension that appears secure and that covers your living expenses, then you can afford to take as much or more risk than your risk questionnaire says you can. Understand, though, that everyone's perceived tolerance for risk is far greater than one's actual tolerance for risk. It takes a severe market downturn to prove this point. Bull markets tend to increase the risk profile of a portfolio because one is loathe to reduce an overweight position because it's obviously going to continue to increase in value. Again, it takes a severe market downturn to demonstrate that a tree cannot grow to the sky. If you don't need to take the risk, why do so???????
What is adequately diversified?
Let's say you fill out a risk tolerance questionnaire saying that you are 50-59 years old, retired, are fairly certain that your current sources of income will continue into the future, have one dependent, have a main objective of generating retirement income now, need the income for at least 20 years, are very concerned about portfolio volatility, etc. Your answers result in the following: You are conservative with low risk tolerance. A suggested asset mix is provided.
This looks pretty complicated but it can be distilled down into 30-36% equities, 62-65% fixed income, and 2-5% money market funds, i.e., cash. Historically, having US and international equities in a portfolio had a counterbalancing effect on Canadian equity performance. It is arguable that the effect still exists because of globalization and the resulting integration of economies. Global equity markets are more likely to move in sync as a result. Notwithstanding, a case can still be made for continuing with a significant foreign equity component: it reduces the risk of having one's equity eggs in a single Canadian basket.
In a low interest rate environment, holding fixed income in a portfolio is often questioned because the return is so poor. A diversified portfolio is meant to reduce risk, not maximize returns. Once again, it takes a severe market downturn for one to realize that I guess I should have had some fixed income in my portfolio.
Possibly the most important decision facing the investor is the division of his (or her) portfolio between high-risk and low-risk components. Traditionally, this is often referred to as the "Equity:Fixed income" allocation, although the "fixed income" component using such terminology colloquially includes cash (which is formally a separate asset class).
To illustrate the effect of the asset allocation on returns during a severe bear market, consider the effect on different Equity:Fixed income mixtures of a year in which equities lost 50% and fixed income (bonds plus cash) gained 5%. The performance will be as follows:
One-Year Returns Equities Fixed incomea Return 100% 0% -50%b 75% 25% -36.3% 50% 50% -22.5% 25% 75% -8.8% 0% 100% 5%
- a. Including cash.
- b. The S&P/TSX Composite Index, which does not include dividends, had a 52-week low of 7479.96 versus a 52-week high of 15154.77 for the year ending Mar. 10, 2009 - a difference of -50.6%.
The equity:fixed income allocations of 75:25, 50:50, and 25:75 correspond roughly in asset allocation to the three FPX Indexes below. Note that the 75% fixed income allocation sharply reduced the effect of the severe drop in equities.
These concepts are further developed in Risk and return.
The maximum expected losses as a function of the equity percentage as estimated by Bernstein are given in the following table:
Risk of Loss Maximum
35% 80% 30% 70% 25% 60% 20% 50% 15% 40% 10% 30% 5% 20% 0% 10%
The simplest portfolios use Guaranteed Investment Certificates (GICs) or single mutual funds. Other simple portfolios are based on using index funds or the corresponding Exchange Traded Funds (ETFs) to build a low-cost structure with a small number of components (generally five or less).
Sector Diversification and Index Concentration
The Canadian stock market is far less diversified than the US market, and is highly dependent on just three sectors: financials; energy (oil and gas); and materials (gold and mining). Therefore, an investor who purchases only Canadian securities may have insufficient sector diversification.
There are several ways to deal with this problem. All have drawbacks or associated costs. Several of these may be used in combination.
- Accept the lack of diversification. This means having little exposure to other sectors like consumer staples.
- Use additional broad equity funds or ETFs from other countries, particularly the US. Depending upon the amounts involved, this may expose the investor to wishes to live and retire in Canada to currency risk, since most of his expenses will be in Canadian dollars.
- Use currency-hedged ETFs or mutual funds. This adds additional costs.
- Use an actively-managed Canadian equity fund rather than an index fund or ETF. This adds additional costs and the fund or ETF may or may not outperform the index.
- Select individual stocks to maintain sector balance. This adds the risk of underperformance, as well as additional costs.
It is also possible for a single stock or small number of stocks to dominate the Toronto stock exchange. Nortel was 36.5% of the TSX on July 26, 2000, before eventually becoming bankrupt in 2009. Although the index methodology has since been changed to limit the holdings to 15%, the relatively small size of the Toronto market still leads to a heavy concentration of the index in a relatively small number of stocks, as is shown in Canadian-US Investing Differences.
The FPX Indexes
The three Financial Post Indexes ("FPX Indexes") constructed by Richard Croft and Eric Kirzner were designed to provide investable benchmarks for measuring portfolio performance. The three indexes are the FPX Growth, FPX Balanced, and FPX Income, and are designed to have high, medium, and low levels of volatility, respectively. Daily values can be obtained from the Financial Post. Historical returns are available on this calculator from Croftgroup.
The 52-week highs and lows in the year ending Feb. 26, 2009, as well as the percentage drops of the three indexes, are shown below:
FPX Indices at 2009.02.26 Index 52-Week
FPX Growth 2659.226 1897.404 -28.6% FPX Balanced 2615.331 2095.094 -19.9% FPX Income 2636.090 2307.389 -12.5%
As expected from its more conservative asset mix, the FPX Income showed the smallest drop of the three indexes during the measurement period.
The GIC or Bond Ladder
One of the simplest portfolios can be obtained by dividing the portfolio sum into several equal parts and investing each part in a GIC which matures in each of the subsequent years. A five-year ladder would have five GICs maturing one, two, three, four, and five years hence. Since certificates maturing more than five years in the future are not covered by the Canada Deposit Insurance Corporation (CIDC), a federally-guaranteed GIC ladder is restricted to a maximum of five years. A similar bond ladder, using Government of Canada bonds, can be extended up to 30 years.
Low-Cost Balanced Funds
One of the simplest ways to obtain a diversified portfolio is to purchase a single balanced or income mutual fund. However, simplicity comes at a price, as the Management Expense Ratio ("MER") of the fund will seriously affect future returns, as can be shown on this OSC calculator.
Rob Carrick has reviewed several of the balanced funds available to Canadians.
The Two-Component Portfolio
A low-cost way to achieve diversification between fixed income and equities is simply to divide funds between a Canadian bond index and a Canadian or global equity fund. Index fund components can be purchased as Exchange Traded Funds (ETFs) or as mutual funds. The ETF approach may be worthwhile for individuals who use a discount brokerage (and thus have low trading commissions). Investors who chose a Canadian equity fund or ETF may not have direct exposure to foreign equities, but some foreign diversification is provided by the pricing of commodities such as oil and gold in US dollars and the non-Canadian earnings of Canadian-based international corporations. ETFs that might be considered for such a simple portfolio include the Barclays bond ETFs XBB or XSB and the Barclays large-cap ETFs XIU or XIC. However, as pointed out above, investors choosing this approach should be aware that the Canadian market is relatively undiversified. Investors who wish a more globally diversified two-component portfolio can substitute a global fund or one of the all-world ETFs discussed in the following section for the Canadian equity component.
The two-component portfolio can be expanded to add additional index funds or ETFs, making a three- or four-component portfolio, when additional funds are available.
Three-Component and Four-Component Portfolios
The four components of a "four-component portfolio" are: Canadian equities; US equities; Europe-Asia-Far East (EAFE Equities); and Canadian bonds. In different combinations, these index fund components can provide a simple means of approximating the composition of the FPX Indexes. For example, the FPX Balanced can be approximated by the following four ETFs:
FPX Balanced Four-ETF Portfolio ETF Amount XIU (iShares™ CDN LargeCap 60 Index Fund) 25% VEA (Vanguard Europe-Pacific ETF) 15% SPY (SPDR S&P 500 ETF) 10% XBB (iShares™ CDN Bond Index Fund) 50%
The Couch Potato Portfolios
The original "Couch Potato Portfolio" was conceived by columnist Scott Burns of The Dallas Morning News. Canadian versions of the portfolio have been designed by MoneySense magazine and are available here. Further discussion can be found at Canadian Couch Potato and Bogleheads Canadian versions of lazy portfolios.
Prebuilt portfolios in the form of mutual funds or ETFs, with different asset allocations or maturity dates, are offered by several vendors including ING Canada and TD Investment Services. Barclays Canada also offers several "Portfolio Builder" ETFs.
Rebalancing is part of portfolio maintenance, and should be done periodically or as circumstances require.
More sophisticated investors may wish to move beyond simple four or five-component ETF or mutual fund portfolios and either include additional components ("slicing and dicing") or purchase individual stocks and bonds. One popular addition to simple portfolios for some investors is Dividend Growth Investing, in which investors may invest in individual stocks. Other investors may seek to diversify into further asset classes such as emerging market funds or ETFs, Real Estate Investment Trusts (REITs), High Yield Bonds, inflation-indexed bonds (Real Return Bonds, or RRBs), or even gold or commodities. The resulting portfolios may contain numerous asset classes and subclasses, and can be very individual in nature. This allows tailoring to meet the goals of an individual investor, but at the cost of additional complexity and monitoring.
Here is an example of a complex portfolio for a 60-year-old retiree. The REITs, preferred shares and high yield bonds boost income, while the real return bonds and gold provide inflation protection. This type of portfolio requires more frequent monitoring.
Example of Complex Portfolio Asset Type Allocation Canadian Stocks 15% Canadian REITs 5% US Equities 5% International Equities 10% Preferred Shares 5% Gold 5% High Yield Bonds 5% Real Return Bonds 20% GIC Ladder 20% Cash 10% Total 100%
Building a Portfolio
The following example is used with permission of the original author:
Ed is in his mid-thirties and wishes to start DIY investing. He has an RRSP worth $10K and no non-registered investments. He wishes to add to the RRSP using monthly contributions. The RRSP is currently in Canada Savings Bonds, and there are no costs or delays associated with moving it. As shown in the section on index funds, with a modest investment amount and the desire to add monthly contributions, low-cost index funds are a better alternative than exchange traded funds. Ed reviews Bylo's list of low-cost Index Funds, and decides to use the TD e-funds for his portfolio. [The TD e-funds are used for illustration purposes only. There are other suitable funds; also, if Ed had more than $150,000 to invest the CIBC Index Funds would have a lower expense ratio.] He establishes an account at TD Waterhouse and transfers his existing RRSP. He wishes to replicate the four-component portfolio listed above, using the FPX Balanced for his target allocation and adding the cash component to the bond index. He purchases the following funds:
Ed's Portfolioa Fund Amount Canadian Bond: TD Canadian Bond Index - e 50% ($5000) Canadian Equity: TD Canadian Index - e 25% ($2500) US Equity: TD US Index - e 10% ($1000) EAFE Equity: TD International Index - e 15% ($1500)
- a. Index funds from other vendors could also be used.
Since both the RSP and non-RSP International Index e-funds have the same MER, it doesn't matter which one he uses from a cost basis. However, the non-RSP version has no currency hedging and tracks the MSCI EAFE Index (in C$) more closely.
Although Ed is very nervous about investing in equities because of the volatility, he recognizes that his time horizon is very long and decides that for now he will use his monthly contributions to add to his Canadian index holdings. Ed decides to use 5% absolute/25% relative for his rebalancing thresholds; if one of the holdings varies from the nominal level by 5% absolute (e.g. from 50% to 45% or 55% for the bond index) or by 25% relative (e.g. 7.5% to 12.5% for the US RSP Index), he will rebalance by redirecting the monthly contributions appropriately until the holdings are back to their nominal percentages.
More complex examples would include factors like consideration of the tax or deferred-charge implications of selling current high-MER mutual funds, and could require the services of a Financial Planner.
You should review the performance of your portfolio at least annually, to ensure that it is meeting your objectives and is consistent with your plan. Further Reading provides a couple of very useful references on the subject.
- William Bernstein. The Four Pillars of Investing: Lessons for Building a Winning Portfolio. McGraw-Hill, 2002. ISBN-10: 0071385290
- William Bernstein. The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk. McGraw-Hill, 2001. ISBN-10: 0071362363
- Charles D. Ellis. Winning the Loser's Game: Timeless Strategies for Successful Investing. McGraw-Hill, 1998. ISBN-10: 0070220107
- George E. Hartman. Risk is Still a Four-Letter Word. Stoddart Publishing, 2001. ISBN-10: 0773761101
- Tom Bradley, Steadyhand Investment Funds. How Is My Portfolio Doing ... And What Should I Do About it? A Framework for Assessing Investment Performance, January 2011
- Tom Bradley, Steadyhand Investment Funds. How Is Your Portfolio Doing? A Framework for Assessing Investment Performance, January 2012
Other useful titles can be found in the Recommended Reading section.
- Definition, from investopedia, viewed Oct. 31, 2011.
- Edmond Financial Group Inc, Risk Tolerance Questionnaire, viewed May 21, 2009.
- TMX Money, S&P/TSX Composite Index, viewed Mar. 11, 2009.
- William Bernstein. The Four Pillars of Investing, McGraw-Hill, 2002. p. 268.
- MSCI Indices, Global Industry Classification Standard (GICS®) Structure - GICS - MSCI, retrieved November 28, 2012.
- iShares Canada, XIC Overview: Sector Breakdown, viewed May 22, 2012. Sector breakdowns as of that date were: Financials, 31.59%; Energy, 25.76%; and Materials, 18.52%.
- CBC News, Nortel's Icarus-like stock, January 15, 2009.
- Wikipedia, S&P/TSX Composite Index, viewed May 30, 2012.
- Richard Croft and Eric Kirzner. Financial Post Indexes, viewed Feb. 18, 2009.
- Financial Post, FPX Daily Indices, viewed February 27, 2009.
- CDIC, What is insured?, viewed Dec 26, 2010.
- Rob Carrick, The right balance: Low fees, high returns, Globefund, September 22, 2009.
- Rob Carrick, The three-dimensional portfolio, Globe and Mail, July 31, 2009.
- Wikipedia, Scott Burns (newspaper columnist), viewed Feb. 18, 2009.
- ING Direct, Streetwise Funds, viewed Feb. 22, 2009.
- TD Investment Services, Mutual Funds, viewed Feb. 22, 2009.
- Barclays Canada, Portfolio Builder iShares Funds, viewed Feb. 22, 2009.
- "Shakespeare", Building a Portfolio, viewed February 22, 2009. Modified to Wiki format and reworded slightly.
- "Bylo Selhi", Low-MER, No-Load Index Funds Available in Canada, viewed Feb. 21, 2009.