Thursday, 24 July 2008

Asset Allocation: the Most Important Investing Decision You Will Make

Asset allocation is the process of splitting up investment dollars into the buckets called asset classes. It is the most important investment decision since the allocation will determine both the level of return you can expect and the amount of variability and risk the portfolio will have.

Some of the main asset classes to consider for a balanced diversified portfolio:
  • cash / Treasury bills

  • bonds, with further useful (i.e. with diversification benefits) subdivisions into real return, corporate, government and international

  • equities, with useful subdivisions into large cap, small cap, value, international Europe, Australasia, Far East (EAFE) and emerging markets

  • real estate, purchasable primarily in the form of Real Estate Investment Trusts (REITs), though one's home can be considered an investment to a degree

  • commodities - energy, minerals, foodstuffs, gold, basic materials (steel, aluminium)

How much to allocate to which asset classes? There is no single determinate right or wrong answer. The approximate right answer depends on how much risk you should and can handle and your investing goals, as discussed in previous posts.

To get an idea what the different asset classes might return over the long term future, look at this table from a 2005 presentation by the Chief Actuary of Canada at a National Academy of Social Insurance Conference. Real returns are net of inflation. The Bank of Canada's inflation target is 2%, the middle of an allowable 1-3% range. Note that the asset mix or allocation then determines the overall expected portfolio return according to the portion in each type of asset. These are numbers the Chief Actuary uses to monitor the Canada Pension Pension Plan Investment Board's performance investing your CPP contributions to eventually pay you CPP, so we can assume that a lot of thought and considerable caution has gone into the numbers. There are no double digit returns to be expected no matter what you invest in!

Some tools that you can use to get you started with the allocation process and help you develop your own mix:
TD Waterhouse Portfolio Planner - answer 8 questions and get a sample asset allocation
Bank of Montreal Investor Profiler - choose a family scenario like your own and get a sample asset allocation
iShares Asset Class Illustrator - pick from a list of asset classes and see how that combination would have done in the past

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