Step 3 – Developing your Investment Strategy for Long Term Assets

Ben Graham Core Principle:
“The secret to your financial success is inside yourself. If you become a critical thinker who takes no Wall Street “fact” on faith, and you invest with patient confidence, you can take steady advantage of even the worst bear markets. By developing your discipline and courage, you can refuse to let other people’s mood swings govern your financial destiny. In the end, how your investments behave is much less important than how you behave”.

Your unique strategy will be effective if it reflects your personality and your experience as well as your financial position. What “Frank, Harry or Sally” are doing is not relevant. As well, your strategy also has to be realistic. Yes it is important that we begin with the “theoretical correct” but if your strategy keeps you awake at night or it is too challenging to maintain for any reason, it does not make sense for YOU. Your strategy has to be sustainable today and in the future. It will also evolve as you evolve throughout your lifetime.

Therefore there are several sections in this Step as your unique strategy will be developed from several different angles. Inputting “numbers” and the answers to a few questions, into a software programme, will not develop your ultimate strategy solution because it does not address your personality and your specific experiences. I wish it was that simple. However, any computerized approach ignores the human side of the equation. It is easy to make the “numbers” make the case for a specific strategy as numbers are more tangible than the softer characteristics. However, many people have lost money – very tangible and very permanent - when they have ignored the softer components – they invest in a strategy that they think looks good financially and technically but does not meet their softer side characteristics. Then the market falls (temporarily) and these investors sell, never to go back and permanently lose their hard earned cash.

A. Market Risk

History does repeat itself. We all know that. What we also know is that it is never quite the same this time as it was last time – so it is very difficult to predict when history will repeat itself and exactly how it will.

Risks cannot be avoided.  However you can decide which risks to take and how to manage them.  Even if you put all of your money into government treasury bills, you put yourself at risk of:

o Not protecting the value of your money;
o Reinvestment rate risk which is reinvesting in lower and lower rates;
o The risk of not meeting your financial goals; and/or
o The risk of that government being downgraded or defaulting.

This is just one example of how even trying to be “risk free” creates risk.

When it comes to risk in the financial markets, there are many risks to be managed. Market risk will be dealt with here and other risks in future Steps and the Blog.

Market risk is the risk of the financial markets falling significantly enough that it hurts when you need the money or beyond what you can emotionally handle. Over the past 100 years there have been many periods when this has happened. Each negative market has been different in terms of what parts of the market fell the most and how long the negative market lasted for. However, what has been consistent, is that having a component of bonds in a portfolio, with stocks, during these periods has reduced the negative returns. Thereby allowing investors to get through the negative market and benefit from future positive markets.

The term "Asset Mix" means the mix of your portfolio strategy between cash, bonds, stocks and other assets such as real estate.  For this Step we will consider asset mix to be the allocation between bonds and stocks in your portfolio strategy.

I have always said that an investor needs to have at least 20% in bonds to reduce market risk without reducing potential returns and at least 20% in stocks to enhance returns without increasing market risk. Ben Graham in his famous book, ‘The Intelligent Investor’ written in the 40’s and rewritten in the 70’s recommends 25% at either end.  My caluclation is based on the historic returns of the markets and Ben Graham's I believe is based on his own experiences.

Each of us is different. Each of us can sustain different levels of negative returns. To determine what we can handle is a purely emotional decision. It has nothing to do with how much money you have or don’t have or how much money you need. It is not a function of your age.

Yes, emotional – some of us are uncomfortable with this, however it is the truth. In working with many investors over the past 20 plus years, I have often met people who think if they say they can handle a high level of downside risk, they appear strong. What is important and shows courage is to be honest with yourself. Because when the market does go down, if you have been honest with yourself, you will be able to sustain the downside risk and not sell which will make you financially stronger. If you are a couple or a family network looking at this, there may be diverse opinions. Spend the time discussing it and coming to a conclusion that everyone can live with.

The following link leads to a PDF file with a table that illustrates what different asset mixes did based on market index returns during 2008 (the last market correction) and 2009 (the recovery) as well as each asset mixes’ long term average return for planning purposes.  I have also referenced another firm’s online tool that I believe is very good for looking at downside risk.

Downside and Returns PDF

Think about the size of your portfolio and imagine losing (temporarily but for a year or more) the actual dollar amount that represents 5%, then 10%, then 15%, then 20%, 25% and 30%. When you feel sick to your stomach, you’ve reached your “uncle” point. Write that number down and the asset mix that reflects it. This is not the sole driver of your asset mix so feel comfortable making the decision without feeling you’re locking yourself into a particular asset mix.

Also, downsides are real. Do you know how many times I heard in the 1990’s and early in this century that what happened in 1973/74 would never happen again? Everyone had wise and sensible reasons why too. Those who said “you never know” and went along with understanding their risk tolerance did considerably better in 2000-2002 and 2008 than other investors. You really need to leave your head at home for this exercise and listen to your heart.

One argument against bonds currently is that interest rates are going to rise and thus you do not want to be in bonds. Well, here’s the thing:

• No one really knows if interest rates are going to rise. Japan has experienced a zero percent interest rate since 1987;
• When we get into the manager section, it’s important to have a good bond manager executing your bond strategy. The word “good” is subjective however for illustration purposes here, you need a bond manager who is paying attention to the movement of interest rates and the quality of the bonds they are investing in to help protect your capital in this part of your portfolio; and
• Remember that interest rates rose through the 1970's until 1980 in North America (“the Great Inflation”) and bonds still added value in the 1973/74 crash.

Action - Record the asset allocation that corresponds with your downside tolerance.

B. Your Return Requirement

This is a mathematical calculation.  Once you have caluclated it, there are three possible outcomes:

1. Your required rate of return is too high meaning that it is not achievable;
2. Your required rate of return is possible; or
3. Your required rate of return is very low and thus gives you a lot of flexibility in the markets.

Purchasing Power Risk is the risk that your dollar today is not worth the same in the future and it is related to your Require Return – for example:

• Assume today $1.00 buys a bottle of water at your local corner store.
• Assume an average annual inflation rate of 2%-in 20 years, that same bottle will cost $1.50.
• Assume an average annual tax rate of 35% for illustration purposes.

  • Today to buy that beverage you need to earn $1.55 approximately to have $1.00 after tax to buy the beverage.
  • In 20 years assuming the same tax rate, you will need to earn $2.30 to buy the same beverage.

So in this example, for every dollar in our portfolio today, it needs to grow to $2.30 in 20 years. When you do the math, this means an average annual return of:
• 2.00% before tax or
• 4.25% including tax (using the same tax rate)

Therefore everyone's minimum required rate of return is 4.25% on average each year.  This is our base line.

Now the disappointing part is that we have not yet to incorporated fees. There are fees in every investment vehicle. A bank deposit like a GIC has an embedded fee of 1-2% which is the difference on government bond portfolio return that the Bank receives (at a minimum) and the rate the bank pays you. No one in the financial industry, like any other industry, does anything for free. There are no free lunches – period. However, that is okay. People do need to be paid for their work. However, you need to know what you are paying, and for what, and make sure you are happy with it. That you derive value from the fees you are paying. We will address fees in the Blog.

Historically bonds have earned 3% over inflation and stocks about 6% over inflation.  If we assume inflation is 2% one can assume to earn somewhere between 5% (100% bonds) and 8% (100% stocks) on average per year before tax. I would like to suggest that the professionals you use will pay for themselves – in other words that we consider 5-8% as an after fee return.  However, do look at the Blog on fees later to ensure you are not overpaying for your investments.  

I know, somewhere, someone has told that you can earn more than this range of 5-8% on average each year. An average annual return of 10% or 12% is often quoted.  Perhaps you will earned outstanding returns on some investments and in some years. However for planning purposes, assume 5% for bonds and 8% for stocks as an average annual return on your total portfolio.  For example a 50% bond and 50% stock allocation estimated average annual return is 6.5%.  If you do better than your plan – great!  However, plan on the average and hope for the exceptional.

The following spreadsheet will help you determine your required rate of return.

Required Rate of Return

Action - Please record what your required rate of return is and the associated asset allocation that will meet this return.

C. Current Experience

Go back to the spreadsheet where you put your current portfolio, Portfolio Position and Asset Position. For each investment, determine how much of that investment is cash, bonds, Canadian stocks, US stocks, international stocks (non-North American). If you hold mutual funds and are not sure, your financial institutions that you hold them through, can provide you with a “fact sheet” which will show the allocation to each asset class (cash, bonds, Canadian stocks, US stocks and international stocks are all “asset classes”).

Then add up what you have in each asset class.

When you have completed this aspect, you will see what your current asset allocation is.  In the Blog I have created a spreadsheet that may help you if you find this difficult to do.

Action – write down your current asset mix.  Specifically how much you have in cash, bonds, Canadian stocks and foreign stocks.

D. Development of Asset Mix based on A, B & C

Now compare the three asset allocations of sections A, B & C. If there are no differences, excellent – you are balanced where you need to be. Perhaps you need to review what firms manage your strategy and how, which will be dealt with in the next Steps and blog.

If there are differences, how do you reconcile the differences so that your recommended asset allocation meets your experience, risk tolerance and financial requirements? Are you comfortable with the compromises?

One situation that may arise is where the asset mix for your risk tolerance has more bonds than your financial requirement and your current portfolio – would it be a good idea to reduce your risk by increasing your bonds? It would depend on two items: (1) have you been through a market correction with your current asset allocation like 2008 and stayed invested? If so, perhaps you are underestimating your risk tolerance? Or if you believe that you’d rather not go through that again, then perhaps it makes sense to increase your fixed income; and (2) discuss any tax implications with your tax professional and in making the changes and ensure you and your financial professionals execute the change to minimize any tax to you.

Another situation that may occur is where you can tolerate more risk than your financial requirement dictates and more than current position. In other words your risk tolerance would suggest you can increase stocks yet from a financial position you do not have to.  Should you become more aggressive and reduce bonds? It depends on whether: (1) taking on additional risk will add value to your life – if not, do not, perhaps you over estimated your risk tolerance?; (2) you went through 2008 as you are and were relatively “happy” – if it’s not broken don’t try and fix it; or (3) you’ve been thinking of reducing bonds for some time and thus in this case perhaps – do it gradually so you can monitor the change.

Often people will think the financial requirement drives the decision between bonds and stocks.  It does not.  You have to have a good balance between your risk tolerance and your financial requirement and balance it with your experience.

Now you have your Strategic Asset Mix between bonds and stocks.  How much should be in your domestic market and how much foreign?  These are personal decisions however the following are some guidelines:

  1. The bond allocation is best served in your domestic bond market.  For Canadians, this is the Canadian bond market.
  2. Your portfolio is best served with at least 50% of your currency exposure in your domestic currency.  So if you have 30% in bonds, you will want to have at least 20% in your domestic equity market (Canada for Canadians).
  3. In the equity can be allocated for Canadians 1/3rd in Canada and 2/3rds globally which includes the USA, Europe, Asia and Emerging markets.  For Canadians, there is a dividend tax credit for Canadian stocks so you may want to bias a bit towards Canada - or not depending on your objectives.  Thus using the example above, assume one has 30% in Canadian bonds, the stock allocation may be 25% Canadian stocks and 45% global stocks.  This gives 55% Canadian dollar exposure and close to 1/3 Canadian stocks and 2/3rds global stocks within the stock allocation.
  4. Global equity is a large asset class with many ways to execute it.  This will be addressed in the next Steps and the Blog.

Time to move on to who is managing each part of your portfolio and whether you are happy with them.