Let's talk about how to build the perfect portfolio – which, no offence intended, probably looks nothing at all like the one you currently hold.
Most of us lavish a disproportionate amount of our money on Canadian securities. We largely ignore international markets, especially global bonds.
But this is not what financial theory would suggest is optimal.
Theory, as well as history, says that markets are reasonably efficient; in other words, they tend to put relatively accurate prices on things, at least based upon the information available right now. Any individual buyer or seller may be unreasonably generous or stingy, but in bulk those irrational decisions even out, leaving behind a decent estimate of an asset's value.
As a result, most students of finance learn that the smart thing to do is to track the market rather than trying to outguess it. Cheap index funds, which passively shadow various benchmarks, like the S&P 500 or the S&P/TSX composite, typically produce better results than their expensive, actively managed counterparts because they take advantage of this ability of markets to efficiently price stocks and bonds.
But if you accept the notion that markets are efficient, then the best portfolio is the one that most accurately reflects the current state of the entire marketplace – not just in Canada, but around the world.
This ideal portfolio should hold all the world's available investments in proportion to the degree they're actually owned by real investors. It should be much like an index fund that tracks a single market, but it should be much broader. In a perfect world, it would be a faithful, low-cost tracker of the entire universe of investable assets.
That sounds like an impossibly tall order, but I'm indebted to Adam Butler, a senior vice-president and portfolio manager at Dundee Goodman Private Wealth in Toronto, for demonstrating that, in fact, it's relatively simple. Mr. Butler, who blogs at gestaltu.com, figures that seven exchange-traded funds (ETFs) can do a good job of replicating the span of the world's major investments.
He lists seven broad classes of assets – global equities, global REITs, U.S. bonds, international bonds, high-yield bonds, emerging market bonds and Treasury inflation-protected securities, or TIPS. For each asset, it shows the ticker symbol for an ETF that tracks that type of investment.
If you wanted to build what Mr. Butler calls the investable global market portfolio, you would, for instance, put 38 per cent of your money into the Vanguard Total World Stock ETF (NYSE: VT); you would place 24.6 per cent of your money into the SPDR Barclays International Treasury Bond ETF (NYSE: BWX).
These numbers aren't black magic. They're based upon a fascinating paper by Ronald Doeswijk of Robeco, Trevin Lam of Rabobank and Laurens Swinkels of the Erasmus School of Economics. Their work, published in 2014, calculated the actual market value of the world's various asset classes. Mr. Butler's investable version attempts to replicate the relative weights of various types of investments in line with what the researchers uncovered.
The portfolio has a far higher weighting of bonds than most personal portfolios. It also has the vast bulk of its assets outside Canada.
According to financial theory, this should be darn close to the perfect portfolio. But does it actually make sense as a real-life investing strategy?
That depends upon the investor, Mr. Butler says. He likes to ask people a list of five questions to determine whether they have unusual preferences or backgrounds that might make the portfolio a bad fit for them. Some people, for instance, might possess specialized knowledge that would give them an investing edge.
In most cases, though, investors have no compelling reason to strike out on their own. "If you feel your preferences are roughly aligned with those of the average investor, you really should aggressively question why you would want to deviate from the global market portfolio," he says.
At the very least, he says, the global market portfolio makes an excellent benchmark for active investors who want to track how well they're doing. It also serves as a reminder that investors should think carefully before they decide to part company with the market consensus.
"Any deviation represents an active bet," Mr. Butler says. "There can be excellent reasons for making those bets, but you should be aware you're making them and understand why you're making them."
Why deviate from a global market portfolio?
Adam Butler of Dundee Goodman Private Wealth in Toronto likes to ask clients five questions to assess whether they have good reasons for deviating from a global market portfolio.
1. What extra insight or intelligence do you possess that the person who will be selling the asset to you does not possess?
2. Alternatively, what non-diversifiable risk are you willing to endure from owning the asset, which other investors are not prepared to endure and from which you expect to derive excess return?
3. What structural barrier is preventing other investors from pricing the asset appropriately?
4. How might your preferences as an investor cause you to derive greater utility from the asset than others might?
5. Once you own the asset, what is your target return for bearing the risk, and what would cause you to sell it?
Bottom line: If you don't have a fairly specific answer to one or all of these questions, why should you think you will be successful in earning returns in excess of a diversified portfolio?