Asset Allocation – Part 1: Risk Assessment

whats-in-your-portfolioThe premise of this article is that “Risk Assessment” is designed by the financial industry, and does not provide any useful indicator for the individual investor. I’ll argue that “Risk Assessment” has no bearing on proper Asset Allocation. Rather, your age is what should determine your investment risk.

What is Risk Assessment?

Mutual fund and insurance companies understand “risk assessment” very well.  In fact they have it down to a calculated science, highly correlated with human behaviour and piles of statistics.

For mutual fund dealers and investment advisors meeting with new clients, it all begins with the “Risk Assessment Profile” or whatever term you want to call it. Through a series of simple and multiple-choice questions, this exercise helps the mutual fund representative determine your investment profile and risk tolerance.

From these questions the mutual fund representative then determines how much “risk” you can handle. This becomes the percentages you should invest in equities, bonds etc. and the mutual fund rep then creates a basic portfolio of mutual funds to suit your needs. In other words the entire asset allocation of your portfolio comes down to a 10 minute questionnaire on your investment feelings and perceptions.

However this is one of several reasons, which led investors into the big allocation mess for them in 2008. Why did so many retirees end up with 80% growth stock portfolios with high risk sector funds before the infamous crash? Anyone who watched their investment s plummet in 2008 and early 2009, knows how scary and real the market meltdown was – and how a large equity portfolio can take a hit in a very short period of time. Let’s track back and look at the Risk Assessment again and why it’s innately flawed.

Why Risk Assessment is Irrelevant

Without going into shelves of library books and research, your brain gathers impressions on what events are occurring within a given time period and then draws a conclusion. Since the financial markets are so complex and have so many variables, your brain has difficultly in drawing a definitive conclusion – and thus creates a perception that can change from one day to the next. The business news thrives on this change of perception, with raging optimism and gloom and doom scenarios all in the same week (All the more reason to switch it off and stick with your strategy).

So a “Risk Assessment” really comes down to your personal perception of what is happening in the market on any given day, and how optimistic or negative you happen to feel about the stock market at that moment.

Bias in Risk Assessment

Let’s pretend that next Tuesday you have an appointment with a new mutual fund dealer. You know ahead of time that you are going to be filling out a questionnaire (risk assessment) on your investment preferences. What you don’t know is what is going to happen in the markets from now until then.

If the market hasn’t been doing well and declining, then you are likely going to feel negative about the markets and lean towards bonds or a balanced style portfolio.  Your brain has an impression that markets go down so you will likely be more cautious. Joe Hypothetical who is 25 but very cautious in nature, could score very high on fixed-income, when in fact he should be focused on more growth.

Conversely if markets have been steadily rising and doing well, that makes a positive impression and you will likely gravitate to more risk. You would likely score a higher percentage for growth (stocks) in that scenario. This is exactly what happened to investors before 2008. They saw climbing markets over several years and allocated more of their portfolio to growth.  So Joanne Hypothetical at 55 years of age could end up scoring very high on growth, when in fact she should be investing in Joe’s fixed-income portfolio.

Your Age is a Better Risk Assessment

Proper Asset Allocation has nothing to do with how you “feel” about the stock market – at least it shouldn’t be.

Proper Asset allocation should be based on how close you are to retirement or how many years you have left in your investing journey to take advantage of stock growth. Conversely, if you are nearing retirement you shouldn’t be focused on growth, you should be focused on income and preserving capital. You simply would not have the time to recover from a major market decline (like 2008 and 2009). So considering the above, your age is much more important than your feelings and emotions about the market.

For example, someone in their 80’s (or even their 70’s) shouldn’t be holding any stocks or bonds at all. They should be 100% invested in GIC’s, since capital preservation is key, not growth!

Proper Asset Allocation

Even with the threat of looming interest rates, and a supposed bond-bubble, bonds are still going to provide you with income and stability.  Most financial experts agree that you should hold a fixed-income basket approximate to your age. Stick with the adage of bonds and fixed income = your age, and the rest in stocks or index funds and ETF’s. So in my 40’s I should have 40% in fixed income and bonds, and the rest in stocks. This adage helps to reduce your exposure to the stock market as you get older, and gives you a cushion in the event of another 2008 & 2009 crash. The older you are the less time you have to recover from significant market declines.

What about Rising Interest Rates?

Just when everything seems so simple, record low interest rates threaten to erode the fixed-income portions of investor’s portfolios.  The simple reason is bond prices decrease as interest rates rise. With record low interest rates, bonds and bond funds are going to lose value. The harbour of safety in bonds and fixed income may not end up being so safe after all. This could end up being another hit for investors just like stocks were in 2008.

But no one knows how quickly or slowly interest rates will rise, or whether stock markets will continue their epic climb. If markets tumble like 2008, then bonds will provide a harbour of safety once again -as they did in 2009. So keeping a balanced portfolio allocated to your age is the key.

Conclusion

Risk comes through in your asset allocation and the individual investments you hold – not how you feel about the market. Next week In Asset Allocation: Part 2, I’ll take a look at some sample portfolio models for various age groups, and why they work!

19 Responses to “Asset Allocation – Part 1: Risk Assessment”

  1. Well written! Emotions have no place in defining a risk allocation. Consequently, I am a little below my target with fixed income allocation … It’s probably important to review automatic re-balancing of assets if you have it. Otherwise it will keep the same balance. Our company RRSP provides the re-balancing and I will need to adjust it at some point. Otherwise my fixed-income gap will grow and so will my risk.

  2. The Dividend Ninja

    Feb 07. 2011

    @PIE
    Thanks for your comment :)

  3. Michel

    Feb 08. 2011

    Interesting, and I think you are right. My thinking is that your financial wealth is also a factor; do you need that money anytime soon? If you have much more money than you need or spend, then you can afford more risk.

  4. The Dividend Ninja

    Feb 08. 2011

    @Michel
    Hi, thanx for posting :) A couple of points.

    If you need money for the short-term then hold it in a TFSA so you can easily withdraw that money without paying tax. Also don’t hold any growth in a short term account – you don’t want to be withdrawing when the value is down. Growth investments need time to grow.

    Second if you have much more money than you need and spend, you cannot afford more risk. Quite the contrary you should be more cautious, and only have a small portion of your investments for “risk”. So keep to your asset allocation regardless of size, and keep the core portfolio safe.

  5. retirebyforty

    Feb 11. 2011

    Risk tolerance still have a place in asset allocation. What if you have 2 thirty years old people. One doesn’t mind the fluctuation and the other have a heart burn whenever there is a drop. Sure, you can put 30% in bond for both of them, but the one with more risk tolerance can invest more in emerging market and small cap. right?

  6. The Dividend Ninja

    Feb 11. 2011

    @retirebyforty
    Hello 40 (or not 40 yet). For the record I am over 40 and not retired! I was waiting for this question so thanx for posting. This is something I’m going to get into in the second or third part of the series (after my preferred shares post). What you are referring to is the actual choice of investments within the allocation – and of course you’re right that is also another level of “risk”. We are both on the same page here. Please keep in mind I am not a professional advisor, and really portfolio allocation is a personal choice.

    Both investors should ideally have a 70/30 split for growth/income. For Joe Cautious he may not feel comfortable with the 70/30 split, so I would actually suggest up to 60/40 split because if the markets drop 5% he will lose sleep over it. So he might as well invest conservatively now and feel comfortable with his portfolio. Obviously emerging markets and sector funds are not something he should be in.

    On the other hand Joanne Emergent loves risk! – at least she thinks she does until markets decline. It’s always easy for investors to become blind to risk in rising markets. She also should keep a 70/30 split for growth/income. But as you suggest, she can put 10% or even 15% (of the 70%) into emerging markets or small caps because she is not risk avoidant. What I would feel is foolish, is for Joanne Emergent to start going 80% or 90% growth, and abandoning the fixed-income section of her portfolio. That’s really the point I am trying to make in the article.

    This is the trap that people fell into prior to 2008 – they forget about asset allocation in the first place – and loaded up on growth and sector mutual funds while markets were rising. You might be surprised to know, but at the 2008 crash may retirees and 50 somethings had 90% or 100% growth portfolios, and even with 10% in high risk sector funds. Some of them are just starting to break even, and some never will.

  7. Kelsey

    Nov 30. 2011

    I really enjoyed how you covered the topic of risk assessment, and investing wisely based on age.

    I noted that you said, “So in my 40’s I should have 40% in fixed income and bonds, and the rest in stocks.” Would you suggest the same ratio for someone in their 20’s?

    PS- I got a good laugh out of, “The business news thrives on this change of perception, with raging optimism and gloom and doom scenarios all in the same week.” Thanks for making investing educational and entertaining, all at a level a semi-newbie can understand and appreciate.

    • The Dividend Ninja

      Nov 30. 2011

      Kelsey thanks for your thoughtful comment, appreciated!

      Yes that is exactly the idea, bonds % at your age (or a combination of bonds and fixed-income), and the rest in stocks. But if your young and stocks make you nervous, then increase the bond allocation ;)

      Remember to keep the bonds short (primarily 1-5 year duration) with the possibility of interest rate increases. Though something like TD Canadian Bond Index (e-series) will still have a percentage of short-term bonds. The whole idea of holding bonds however is to give you the cushion in turbulent markets, the strategy has worked for decades regardless of interest rates. Andrew Hallam covers this very nicely in his new book Millionaire Teacher.

      Cheers!

      • Kelsey

        Nov 30. 2011

        Thank you for your thoughtful answer. I will definitely be following your advice.

        I appreciate you taking the time to share your invaluable knowledge. I’m off to Amazon to see about that book.

        I’ll be keeping a look out for your book in the future! ;)

  8. The Dividend Ninja

    Nov 30. 2011

    Kelsey thanks for your thoughtful comment, appreciated!

    Yes that is exactly the idea, bonds % at your age (or a combination of bonds and fixed-income), and the rest in stocks. But if your young and stocks make you nervous, then increase the bond allocation ;)

    Remember to keep the bonds short (primarily 1-5 year duration) with the possibility of interest rate increases. Though something like TD Canadian Bond Index (e-series) will still have a percentage of short-term bonds. The whole idea of holding bonds however is to give you the cushion in turbulent markets, the strategy has worked for decades regardless of interest rates. Andrew Hallam covers this very nicely in his new book Millionaire Teacher.

    Cheers!

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