A Written Investment Policy, Don't Invest a Cent Without It

Once you have done all the homework described in the preceding posts, it makes sense to capture the conclusions and to write down how you will manage your investments - the objectives, the assumptions and the rules by which you will buy and sell. The fancy title for this is the Investment Policy Statement.

This need not be a daunting 20-page document. In fact, try to make it too long and detailed and it won't get done or followed (think of how well those 500 page policy manuals at work are followed!).

Below is a table with two fictitious examples of how such a policy might look. Please note that they are for illustration only and should not be taken as advice. You need to do your own.

Note how the examples differ according to the different circumstances of the investors. They reflect objectives, risk tolerance, time horizon, capacity and interest in actively managing the investments, existing assets and expected returns or income.

One thing not included but which could be is "who decides". Most times, it is an individual decision, but with a couple, it might be valuable to discuss and decide together. If you can't convince your better half, then maybe a buy or sell isn't very good. Men and women think differently and sometimes we men are too action-oriented, sometimes even too aggressive.

Two important benefits came out of doing my own. First, it made me think about what should be in each box and come up with a logic and a reason. My investing is more coherent and less random or impulsive. Second, once written down, it becomes much easier to stick with, especially in times like now when stock markets are not doing so well.

It is important also to realize that a perfect plan may not exist. A "pretty-good" plan is much better than no plan at all. Get started and do one, then improve it later.

The policy should be good for years, though it should be revised when major life changes occur, such as marriage, the arrival or departure of children, a major job shift, illnesses, deaths, retirement, inheritances.

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

How to Diversify without "Diworsifying"

Diversification is the name investing theory gives to the principle "don't put all your eggs in one basket". Let's expand the analogy a step further.

Buy More than One Egg: When buying investment "eggs" it is a good idea to buy more than one - if one breaks or goes bad there are others to eat so you do not go hungry. Similarly an investment in one company is risky since management may mess up. Buying more than one company's stock is a wise thing. That is the first way in which diversification reduces risk while allowing you to obtain the benefits of higher return investments.

If you buy several mutual funds and they happen to hold the same companies within them, then all you have done is buy more of the same companies and you have achieved diworsification. Buying more of one company increases your exposure to that company's fortunes and makes your overall holdings riskier and therefore worse. When you buy any collective investment like funds, you need to look inside at its holdings to verify that it is substantially different from what you already have.

Buy More than Just Eggs: Ever notice that when good or bad economic news comes out, often the shares of a whole sector such as banks or oil companies go up or down together, or perhaps even the whole stock market? That phenomenon is called correlation. Investments that change value or move up and down independent of each other are said to be un-correlated and if they move in opposite directions (if one goes up the other goes down, but only temporarily since all investments should move up eventually - each has its day to shine), they are termed negatively correlated. Combining un- or negatively-correlated investments, such as real estate and stocks, smooths variations and reduces risk. A grouping of investments that behaves similarly is known as an asset class. Thus the second way to diversify is combining in a portfolio these non-correlated investments, non-eggs in our analogy. In investing, as in food, eating only one thing, though it may be good for you, is likely to give indigestion or worse. A balanced diet is advisable and a combination of ingredients, or asset classes, can make a tastier dish than a single ingredient. The combination is better than the sum of the individual securities.

Diversifying amongst multiple asset classes for a given level of return will minimize the risk. It is important to note that the correlations among asset classes can vary tremendously from year to year despite the long term tendencies. However, despite the fact that the investing world is not fully predictable or stable, it is possible to build a darn good diversified portfolio that will give excellent stability and higher return.

In the next post, I'll describe the major asset classes and how to combine them in a portfolio.

Further reading:
Investor Solutions - Chapter 5 Travels on the Efficient Frontier
Richard Ferri's book - All About Asset Allocation
InvestorHome article on Asset Allocation

Risk: What Can You Afford and What Can You Put Up With?

Risk is the chance of loss. Loss only occurs when you sell the investment, not during fluctuations in value, such as happen every day in the stock market. Unfortunately, it may be difficult to decide whether a decline is permanent or temporary - is Nortel ever going to bounce back to its former lofty heights? - and how long "temporary" might be.

Some investments, like GICs, do not change much in value, always moving ever so slowly upward. No problem there. With equities, however, there is variability, often quite a lot, even though over the long term, stocks do gain by much more than GICs.

This dilemma can lead to several undesirable outcomes. First, if you actually sell after a decline, there may be less cash than needed for an investment goal like education. Second, if you get worried, panicky or impatient, you may sell prematurely, what might be called buying high and selling low, the exact opposite of the dictum to "buy low and sell high".

These two outcomes should lead any investor to examine him or herself from two perspectives:
1) What you can afford to lose without disastrous financial effect, the rational weighing of the ability to bear risk and possibly sustain losses? Here are the factors to consider -

• financial assets - the more you already have, the less the impact of a loss and the more you should be able to bear risk
• present and future income - the more you earn and especially the more you have as disposable income now and looking ahead, the better chance you have of bouncing back from losses
• time horizon or length of time before you will need the money - the longer you have, the more you can afford to wait through the fluctuations of the stock market, for instance ten years or more
• liquidity needs - similarly, the less you might need at once, the more it is possible to look to riskier investments

2) What you can sustain psychologically in periods of downturn for investments like equities? Some factors here:

• sleeping at night - how much of a decline does it take to ruin your peace of mind; apart from the mental anguish, a weaker stomach can lead to selling too early, so often it seems just before things begin to go back up.
• impatience - if you get frustrated and fed up when declines last many months or even several years, investing in stocks that do periodically experience such declines will probably lead you to sell prematurely at a loss, only to miss out on the rebound

There are a number of free risk tolerance questionnaires available that anyone can use to get an idea how the above can lead to a suggested list of types of investments (typically cash, fixed income and various types of equities) and a percentage allocation to each category. Try several and compare results.
Bank of Montreal Investor Profiler - gives separate pre- and post-retirement recommendations; no registration required
IFA Canada Risk Capacity Survey - three versions: ultra-short (5 questions), long (49 questions) and RRSP (19 questions); requires registering to get the results
Edmond Financial Group Risk Tolerance Questionnaire - no registration; very quick to do
MSN Money Risk Tolerance Quiz - 20 questions; gives portfolio composition suggestions

It is significant that knowledge of investing principles increases the tolerance, in both the above senses, for risk. Setting proper expectations about likely rates of return and especially the possible multi-year down periods, gives a greater peace of mind of mind and patience to ride out variability. Knowledge also enables the construction of a portfolio of investments that has less variability and risk of loss and very good long term returns, as will be explored in future posts.

Investing Principles - Minding the Immutable Forces

If you pretend that the laws of physics don't apply to you and try to fly off your roof, you will be in for a painful surprise. Similarly, ignore certain economic forces and you will suffer investing losses or fall far short of financial goals. Use the forces to guide your investing, and success, while not guaranteed, is much more likely.

Force # 1 - The Risk vs Return Tradeoff
To obtain higher returns, you must be prepared to accept more risk. If you want no or ultra-low risk then returns will be low, perhaps so low that all you may effectively achieve is to preserve the value of the money that you save. If you have figured out that you can save enough to fund your goals, even with miniscule returns, then by all means do so. Most people, unfortunately require appreciable growth and that requires riskier investments.

Force # 2 - Diversification Will Reward and Protect You
Diversification means two things: having numerous investments, not just one or two or three and; having different kinds of investments. The first factor protects against potential problems of one company by spreading things around - the not-all-eggs-in-one-basket principle. The second factor takes advantage of the fact that some years stocks do well, some years it is bonds, other years it is real estate and so on. Right now, for example, the front-runner seems to be commodities, oil especially. The different winners at different times extends to countries as well. Diversification will smooth out market variability and enable you to take on higher return investments.

Force # 3 - Inflation is a Stealthy, Debilitating Menace
Inflation has been low for some time but the recent rise in oil and food prices is worrying. If inflation suddenly shoots up to 6%, 4% interest on a seemingly safe GIC is losing you 2% a year. Bonds and T-bills with their fixed interest return, are susceptible to inflation. The real damage happens over many years. A 2% loss after inflation prolonged for five years will erode the purchasing power of the $100 GIC to $90.57, including the interest, per the Bank of Canada Inflation Calculator. Some solutions for inflation: diversification, equities and real return bonds.
Resource: Libra Investment Management's spreadsheet - shows real (after inflation) and nominal (before inflation) returns on various types of investments 1970 - 2007

Force # 4 - Costs Matter, a Lot
As an investor you will incur various costs: trading commissions, management expenses of mutual funds and ETFs and possibly account administration fees. Every 1% extra in avoidable costs is a 1% reduction in net return. The first post in this blog pointed out the large effect of a 1% difference in return can have over a long period. Calculate your costs and ask yourself whether the cost item is too high; maybe it isn't but sometimes it is.

Force # 5 - Taxes Should Shape but Not Determine
Taxes are a constraining and shaping factor. Since interest income is taxed at the highest rate, income investments should be held in accounts with tax protection, such as RRSPs, RESPs and the new TFSA (to start in 2009). But conversely that doesn't mean you shouldn't buy equities in an RRSP just because they generate capital gains and capital losses cannot be deducted to offset capital gains within the RRSP. Investing in something primarily because it generates a tax benefit is a bad idea - it needs to be a good investment first.
Resource: TaxTips.ca - tax rates and account info

Investment Building Blocks - Securities

Securities are the things an investor can buy. There is a mind-boggling array of securities available to a Canadian investor, but never fear, that potentially paralyzing complexity can be simplified.

Consider a food analogy. At the most basic level, there are ingredients - sugar, carrots, peas, beef, lamb etc which can be grouped into vegetables, meat and so on. Thus we have T-Bills, corporate bonds, government bonds, common and preferred stocks, grouped into categories - money market, fixed income and equities.

Those ingredients can then be bought one at a time or as products grouped and packaged in various ways, e.g. tomatoes by themselves or in a pasta sauce along with beef and perhaps sugar. You can thus buy shares of Bank of Montreal by themselves or within a mutual fund, combined with other stocks or with government bonds or both. Much of the confusing complexity arises from all the available combinations.

The chart shows common securities (i.e. it is not comprehensive). The rows are the basic securities and the columns are the product packages, ranging from an individual security to collective investment structures that combine many securities and many investors. The x's in the chart indicate roughly what can be bought in each product.

Basic Securities:

• Money Market - you lend money short-term (days to a few months), to the government by buying T-Bills, or companies through commercial paper, and get back interest
• Fixed Income - you lend money for years to governments or corporations by buying various types of bonds and get back interest payments plus your original investment, which may go up or down if you sell out before the bond maturity date (repayment date) - Details of GIC and CSB on InvestorEd
• Equities - you buy part ownership in a company through shares and get back profits through dividend payouts or through appreciation of the shares as the company grows ... or not get any dividends and see the shares decline in value if the company does poorly. Details of Split-Share on Wikipedia
  

Product Packages:

• Individual - you buy a bond or share of one government or company either directly or on a market
• Mutual Fund - you buy units from the fund company itself (though usually you do so through a brokerage, agent or financial planner), which passes through any profits to you each year
  
• Closed-end Fund has a fixed number of units, essentially shares, that are bought or sold on the stock market
• Exchange Traded Fund (ETF) is, surprise, a fund that is traded on a stock exchange; unlike the closed-end fund has features that ensure the buy/sell price is very near what the stocks/bonds inside are worth
• Income Trust - a corporate structure in which a company passes through all its profits to you the investor (on which you pay taxes, of course)
  

As you can see, there are many ways to satisfy your investing appetite!

Resources and Further Reading:
Shakespeare's Investment Primer
Gail Bebee's book No Hype: The Straight Goods On Investing Your Money

Reviewing Your Financial Assets

A key step to getting organized for investing is to list what you have already - your assets. Your assets include extra cash (above what you need for your immediate spending), GICs, mutual funds, stocks and your pension. The paid-off portion of your house should be on the list too. There are two reasons to do this:

• to find the gap between total current assets and your total investment goals - how far is there to go?
• as a basis for filling in the gaps or making changes to the mix to achieve a balance - what is called diversification or spreading of risk - of your investments.
  

The most valuable asset of all, especially if you are young and just starting your career, is YOU! Why? Through your talent and energy, you are a money-generating machine. You must therefore consider your age and earning power when choosing your investments. Furthermore, the type of work you do should influence how you invest. (Read more: Human Capital and the Theory of Life-Cycle Investing by Paula Hogan of Hogan Financial Management)

Your income and what you can take out of it to invest is another decision to make. Regular, small amounts over many years can grow to huge totals. Use the Advantages of Early Investing calculator at the Fiscal Agents website to play with the numbers and see what amount would get you to your goal. Above all, just get started, no matter how small the sum, and make the setting aside automatic. Don't rely on yourself to "get around to it" because if you are like me and most other people, it won't happen.

In my opinion, these are the resulting investment do's and don'ts:

• if your job is relatively secure and unaffected by the stock market and you will be receiving an inflation adjusted defined benefit pension that will provide most of your retirement spending needs(does this sound like you, teachers, government and health care workers?), then do invest in the stock market/equities, not GICs or other forms of fixed income
• if your job is susceptible to downturns, do include a healthy proportion of stable fixed income in your investments; especially do not invest only in your employer's stock or even that industry (as a former high tech worker who got laid off and had a lot of plummeting high tech shares, including those of my company, I can tell you the ouch factor is high) though stock purchase plans can be a worthwhile exception
  
• do invest in stocks when you are young and can take the extra risk of stock investing for the potential higher long term returns of stocks to reach the large amounts needed for a comfortable retirement
• if you are just starting out investing with small amounts, then you are better off in collective investments like mutual funds and Exchange Traded Funds (explained in the next post) that spread risk over many companies

Please note that the above is my opinion only and should not be taken as investing advice. Consult an advisor registered with your securities commission if you need help.