Welcome to our advanced investor education program. This is the second of a six-part series. You can read the first part here:
Asset allocation is just a fancy term for describing how much of different investment classes - stocks, bonds, cash, real estate, precious metals, rare Cabbage Patch dolls - you should have in your portfolio.
It's related to the concept of - the idea that you should spread your risk across different investments so you won't be overly exposed to a downturn in one particular area. Here's what Investopedia has to say about asset allocation:
"There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make."
"In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results."
Fixed-Income Rule of Thumb
One basic rule of thumb, which can be tweaked to fit each investor's goals and risk tolerance, is that the fixed-income portion of the portfolio should be roughly the same as his or her age. In other words, a 30-year-old investor should allocate about 30 per cent of his or her portfolio to government bonds or guaranteed investment certificates, and the rest to equities. A 70-year-old investor, who has less time to invest and needs to be more conservative, would allocate 70 per cent to bonds and GICs.
The age rule isn't carved in stone, but it's a useful starting point for determining an investor's optimum asset allocation. With people retiring earlier and living longer, some argue that investors need to be more aggressive with stocks so that their money will go further. Others say safety is paramount, given the unpredictability of markets. How much risk you can tolerate, when you'll need the money and how flexible you can be in reaching your goals are all variables to consider.
This nifty calculator lets you play around with the variables to determine the mix that's right for you.
Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:
The 2010 Investor Education series for advanced investors:
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Unfortunately, many investors forget all about asset allocation - until it's too late. That was painfully obvious during the market collapse of 2008-2009, which blindsided investors who had devoted too much of their portfolios to stocks.
"While the stock market is raging like crazy, nobody thinks they need bonds," said Kerry Harman, associate portfolio manager with Burgeonvest Securities Ltd. in Toronto.
Determining how much risk an investor can handle is one of the key ingredients in an asset-allocation plan. When Adrian Mastracci sits down with new clients, the president of KCM Wealth Management Inc. in Vancouver gives them a questionnaire to assess how well they would react in a severe market decline.
"I try to establish where the threshold of pain is. Is it a loss of 10 per cent, 20 per cent, 30 per cent?" he says. He then tailors their portfolio to match their risk tolerance.
Some investors can handle a lot of volatility. For others, even the smallest amount of risk is too much. That's why, even though stocks have generally outperformed bonds over the long-term, some say a portfolio that is 100-per-cent invested in GICs is the way to go. That sort of extremely conservative asset allocation isn't for everyone, but it will at least allow you to get a good night's sleep. You can read more about the GIC-only approach here:
Real Estate, Gold
What about other investment classes? If you own a home, you already have plenty of exposure to real estate, but if you feel your inner Donald Trump calling, you can purchase real estate investment trusts that own office buildings, shopping centres and other real estate assets.
The Invest for Life series:
As for gold, some investors prefer to invest in the metal directly as a hedge against inflation, but if you buy a Canadian index fund you'll be getting exposure to several gold producers, including the world's largest, Barrick Gold Corp. You can read more about it here:
It's probably best not to go overboard on these asset classes, and to focus your asset allocation on high-quality stocks and bonds. And don't forget about cash, which you'll want in an emergency or to take advantage of market drops. The important thing is to find the mix that works for you, taking into account your age, emotions and financial situation.