Portfolio design and construction

This article describes a process for portfolio design and construction. A portfolio is a grouping of financial assets such as equities (including stocks), fixed income (including bonds) and cash. It is a generally accepted principle that a portfolio is designed according to the investor's risk tolerance, time frame and investment objectives.

Portfolios are held directly by investors and/or managed by financial professionals. Mutual funds (including index funds) and exchange-traded funds (ETFs) are typical portfolio building blocks; more advanced investors might choose to select individual securities within the main asset classes.

Once a portfolio has been constructed, there is still a need for ongoing monitoring and maintenance to ensure that the portfolio objectives are being met and to deal with any life events or changes in circumstances.

The outcome of this process should be the basis for your investment policy statement.

Overview of the process
The first step is to make sure you are ready to invest by doing an self-assessment.

The second step is creating a financial plan, which identifies what are the specific objectives of the portfolio, such as retirement or another project, along with a time horizon. If your time horizon is really short and money is being invested that will need to be used within a few years, STOP! Putting your house down payment in the stock market is folly, as return of capital is more important than return on capital.

The third step is to establish an asset allocation, and a savings target, that together are likely to lead to the financial goal being reached within the specified time horizon. The most important decision in the asset allocation exercise is the division between equities (stocks) and fixed income (bonds, Guaranteed Investment Certificates (GICs), High-interest savings accounts (HISAs) and cash), as this is the major determinant of expected portfolio return and expected volatility.

A secondary decision of asset allocation is how much foreign (as opposed to domestic) content to include. For fixed income, keeping it all domestic seems appropriate for many Canadian investors. For stocks, some global diversification is generally advisable, due to several factors including the sector concentration in the Canadian stock market, and the expected reduction in portfolio volatility.

When the appropriate allocation has been established, the fourth step is to implement the portfolio. Examples of both simple (one to five asset classes) and complex (generally more than five asset classes) portfolios are examined here, notably using index mutual funds or ETFs. Security selection within the asset classes is also a possible strategy for more advanced investors.

The fifth step is the ongoing monitoring and maintenance of the portfolio, which consists of rebalancing it to the target allocations, and measuring its performance against an appropriate benchmark.

Assess yourself
Before you create an investment portfolio, create a list of your financial assets and liabilities, or net worth. In general, investing in stocks or fixed income (bonds are a subset of fixed income) should come after other financial needs are met: debts such as credit cards, student loans or consumer debts are paid off; an emergency fund is established; sufficient insurance is in place. 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.

Saving a portion of your income is an obvious prerequisite for investing and building assets. If you are spending more than you earn, it is generally recommended to learn to live below your means. This may require budgeting.

Create 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, and/or ensuring that children get an excellent education. 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.

Set your level of risk (asset allocation)
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" (stocks / bonds) allocation, although the "fixed income" component using such terminology colloquially includes cash (which is formally a separate asset class).

Equity vs fixed income
An age and risk appropriate adequately diversified asset mix (asset allocation) will help protect assets during severe market downturns. What is age appropriate? A rule of thumb is "your age in bonds". So a 40 year old investor would have 40% fixed income (60% equities), and the proportion of fixed income would increase with time. 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.

To illustrate the effect of the asset allocation on returns during a severe bear market, consider the effect of different ratios of equity to fixed income of a year in which equities lost 50% and fixed income (bonds plus cash) gained 5%. The performance will be as follows:


 * {| class="wikitable" style="text-align: center"

! Equities allocation ! Fixed income allocation ! Weighted Return
 * +One-Year Returns when equities lost 50% and fixed income gained 5%
 * 100%
 * 0%
 * -50%
 * 75%
 * 25%
 * -36.3%
 * 50%
 * 50%
 * -22.5%
 * 25%
 * 75%
 * -8.8%
 * 0%
 * 100%
 * 5%
 * }
 * 0%
 * 100%
 * 5%
 * }
 * }

Domestic vs foreign asset classes
Once the fixed income:equity split has been decided, a second important – but difficult to answer – question is how much to allocate to foreign (or “global”), as opposed to domestic, asset classes. For fixed income, most Canadian investors will opt to keep it all domestic. For equities however, there are convincing arguments for global diversification.

Simple portfolios
The simplest portfolios use Guaranteed Investment Certificates (GICs) or single mutual funds. Other simple portfolios are based on using index funds or the corresponding ETFs to build a low-cost structure with a small number of funds (generally five or less) that are easy to rebalance.

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 (CDIC), 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.

Although a fixed income ladder may seem like all that's needed for the most conservative investors, portfolio theory suggests that including a small amount of equities (say 10-20%) in a portfolio may actually increase its return and lower its volatility. And for less conservative investors saving for retirement, a fixed-income ladder alone will probably not have the required expected return: a balanced portfolio combining stocks and fixed income will work better.

One-fund portfolios
The next step in complexity is a diversified (balanced) portfolio, which contains both fixed income and equities. This can be obtained with the one-fund solutions described here, or by building a diversified portfolio using your own combination of equity and fixed-income funds (or individual securities) as described in the subsequent sections of this article.

One-fund portfolios fall into three categories: target date funds, balanced mutual funds, and asset allocation ETFs.

Target date funds are prebuilt portfolios with allocations that automatically change over time. Target-date funds (also known as "retirement-date" or "life-cycle" funds) have been described as the ultimate "set and forget" investment vehicle but they also have been criticized for high fees: "the management and trading expense ratios for these products hover around 2.3 per cent". They also have potential suitability issues.

Balanced mutual funds are diversified portfolios which typically utilize fixed asset allocations, combining fixed income and equities into a single mutual fund. Balanced funds can be appropriate for new investors, as they are one of the simplest ways to obtain a diversified portfolio. There's no need to learn how to trade, or to perform rebalancing. However, simplicity comes at a price, since the average balanced fund in Canada has a management expense ratio (MER) of 2.15%. High MERs will seriously affect future returns (reduce the amount of money you have for retirement), as can be shown on the Mutual fund fee calculator | Investor Education Fund.

Asset allocation ETFs are exchange-traded funds (ETFs) that mix stocks and bonds in various proportions, typically ranging from 20% stocks (so 80% bonds) to 100% stocks. The asset allocation ETFs with intermediate allocations to stocks (say from 40% to 60%) are equivalent to balanced mutual funds, but are passively managed, and have significantly lower MERs. Asset allocation ETFs in general -- including some with more aggressive asset mixes -- are increasingly popular on the Financial Wisdom Forum, for new and experienced investors alike.

One-fund solutions have a behavioural benefit. Investors who have difficulty watching the ups and downs of the market will be less tempted to trade, as movement of the fund's underlying components will be hidden from view. Frequent trading, especially when one attempts "market timing," is very likely to result in lower returns (relative to staying invested at all times).

While cost is certainly important, a one-fund portfolio is preferred for investors who don't want to manage the complexities of multiple funds, or are unable to handle the swings of the market. It is much better to start investing early with a higher-cost diversified fund than to delay or not invest at all.

Three fund, four fund and five fund portfolios
A low-cost way to achieve diversification between fixed income and equities is a three-fund portfolio that divides funds between (1) a Canadian bond index, (2) a Canadian equity fund and (3) a global equity fund. The three-fund portfolio is recommended for its simplicity and diversification.

The three-fund portfolio can be constructed by first selecting an appropriate asset allocation between stocks and bonds, and then dividing the stock allocation between domestic and global. Specific Index funds or ETFs are then chosen to implement the asset allocation. Such a portfolio has several advantages:
 * very simple to understand and implement
 * simple to manage, including rebalancing and paperwork
 * diversified between stocks and bonds according to the investor's risk tolerance
 * the stock portion has global diversification, promissing a lowered portfolio volatility
 * very low costs
 * enables caregivers and heirs to easily take-over the portfolio when necessary
 * no market timing or security selection involved
 * allows you to spend more time with family and friends, and less time managing your finances

A four fund portfolio further decomposes the global stocks into two funds: US stocks and international stocks. The developed markets portion of "international stocks" is also known as Europe-Australasia-Far East (EAFE). The "Global Couch Potato" portfolio from Moneysense and Canadian Couch Potato is a well known example of a four fund portfolio designed for Canadian investors.

A five-fund portfolio separates international equities into EAFE equities and emerging market equities.

Different asset classes (see below) could instead be added to the initial three (Canadian bonds, Canadian equities and global equity) to compose four- or five-funds portfolios.

Complex portfolios
More sophisticated investors may wish to move beyond simple three, four or five-component portfolios and either include additional components; slice and dice existing components; or purchase individual stocks and bonds. 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, if security selection is performed, more frequent monitoring. Another potential issue with complex portfolios is the "urge to tinker": it can be tempting to change one's asset allocation too frequently, etc.

Early-thirties and starting to invest
Diana B. from P.E.I. is in her early-thirties and wishes to start DIY investing. She has an RRSP worth $10k and no non-registered investments. She wishes to add to the RRSP using monthly contributions. The RRSP is currently in a HISA, and there are no costs or delays associated with moving it.

She completes Vanguard’s Investor questionnaire, which comes up with a recommendation of 70% stocks and 30% bonds. Although her time horizon is long, Diana has no experience with stock market investing, and she does not really know how she will react to her first bear market. She is nervous about investing in equities because of the volatility. So she decides that a balanced stock:bond split of 60%:40% will do initially. The asset mix can be adjusted later when she has more experience.

After doing some reading on how to implement this asset allocation, she decides that a low-cost one-fund solution with automatic rebalancing would suit her needs. Several members on the Financial Wisdom Forum seem to think that asset allocation ETFs (see above) are the best thing since sliced bread.

She finds a discount brokerage where ETFs can be purchased commission-free, and moves her existing RRSP there, using the transfer form supplied by the broker. When the $10k shows up in her account online, she purchases an asset allocation ETFs with a 60-40 split from one of the three main providers in Canada (see the list of such ETFs here), using the "initial implementation" steps listed here.

Next month, she can invest her new money (transfered to the RRSP using online banking), plus any cash distributions, into more shares of the same balanced ETF. This will take maybe 5-10 minutes every month.

Mid-life investor ready to take control
Gilbert B., also of P.E.I., has just turned 45 and wants to retire in 20 years. He has a $300k portfolio split between his RRSP ($200k) and his TFSA ($100k). So far, he’s been using an advisor, but the service he’s been getting is minimal and the costs seem too high. So after spending some time on the Forum and finiki, having read a few good investment books, and having played with a practice account at a discount brokerage for a while, he feels that he’s now ready to manage his assets on his own. He plans to add to his accounts quarterly. So he opens a real TFSA and a real RRSP at a discount brokerage which allows commission-free or inexpensive ETF transactions, and instructs the brokerage to transfer his existing accounts.

Gilbert has decided to follow the classic "your age in bonds" rule of thumb, which means he’ll need 55% stocks and 45% bonds for now. To keep things simple, that allocation will be used in both the TFSA and the RRSP (other asset location strategies are examined under Tax-efficient investing).

An asset allocation ETF like VBAL would have 60% stocks and 40% bonds, which would be close enough. However, Gilbert is an engineer who likes numbers, spreadsheets and details. So after reviewing the makeup of VBAL and the competing products from other vendors, Gilbert decides he wants a bit more customization, and he’s willing to do the portfolio rebalancing work himself, in exchange for slightly lower management fees. Specifically, he would prefer to:
 * change the stock:bond ratio in 5% increments every five years
 * split the stocks equally between Canada, the US and international markets
 * avoid emerging markets
 * keep all of his fixed income in Canada.

Gilbert is a candidate for a Simple index portfolio containing four ETFs. He decides to purchase all of his funds on Canadian exchanges to avoid currency conversion costs and US estate tax considerations (see Canadian vs US-listed ETFs for the full pros and cons). He selects broad market index ETFs from one of the three main vendors in Canada using the criteria listed at Selecting plain-vanilla ETFs, which leads the following portfolio:


 * {| class="wikitable"

! Asset class !! ETF selected !! Percentage !! Amount RRSP !! Amount TFSA
 * Canadian bonds || VAB || 45% || $90 000 || $45 000
 * Canadian equities || VCN || 18.33% || $36 667 || $18 333
 * US equities || VUN || 18.33% || $36 667 || $18 333
 * International equities || VIU || 18.33% || $36 667 || $18 333
 * Total || || 100% || $200 000 || $100 000
 * }
 * International equities || VIU || 18.33% || $36 667 || $18 333
 * Total || || 100% || $200 000 || $100 000
 * }
 * Total || || 100% || $200 000 || $100 000
 * }

After reviewing ETF trading tips and watching the "How to Build an ETF Portfolio at …" video (specific to his discount brokerage) from Justin Bender to boost his confidence level, Gilbert feels ready to act. So he purchases enough shares of each ETF to get close to the dollar amounts in the table, for a total of 8 transactions.

This should keep the portfolio close to the targets for a while, but eventually it will need to be rebalanced. This can be done with new contributions for the most part. Each new contribution can simply go to the 1-2 holdings that are the most down relative to targets (see New contribution with ETFs for a detailed example). So each new contribution will only necessitate 1-2 transactions per account.

Gilbert also decides to check once a year if his portfolio requires further rebalancing, using a 5% absolute/25% relative tule (see Rebalancing for more information).

65 year-old retiree
Not every investor will be satisfied with Asset allocation ETFs like Diana, or even simple index portfolios like Gilbert.

Here is a hypothetical example of a complex portfolio for a 65-year-old retiree.


 * {| class="wikitable"


 * +Example of Complex Portfolio
 * align="center" style="background:#f0f0f0;"|Asset Type
 * align="center" style="background:#f0f0f0;"|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%
 * }
 * High Yield Bonds||5%
 * Real Return Bonds||20%
 * GIC Ladder||20%
 * Cash||10%
 * Total||100%
 * }
 * Cash||10%
 * Total||100%
 * }
 * Total||100%
 * }

The Real Estate Investment Trusts (REITs), preferred shares and high yield bonds boost income, while the Real Return Bonds (RRBs) and gold provide inflation protection. This type of portfolio may require more frequent monitoring if security selection is employed.

Note
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.

Rebalancing
Rebalancing is part of portfolio maintenance, and should be done periodically or as circumstances require.

Measuring performance
You should review the performance of your portfolio 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.

One year, 3 years, 5 years and 10 years portfolio returns can be compared to suitable benchmarks, such as the FPX indexes, or home-made ones closer to an investor's actual asset allocation.

To calculate one year portfolio returns combining several accounts, Excel aficionados can use the XIRR function as described by gummy, in two different tutorials: XIRR and XIRR and its uses. XIRR calculates a money-weighted rate of return.

A more up-to-date (and maintained) tool for calculating personal returns has been developed by FWF member longinvest. The tool calculates both a money-weighted return (which takes withdrawals and additions into account) and a time-weighted return (which does not). The latter is the way mutual funds and ETFs report their performance, and is ideal for comparing different portfolios or managers. On the other hand, the money-weighted return reflects the actual experience of specific investors, so the tool calls this the "investor return".

To calculate annualized multi-year returns, the Excel function GEOMEAN can be used (see this Gummy tutorial).