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.