Asset Allocation

 

There are a lot of ways to split up your investments and to try to strike a balance between potential returns and safety, convenience and diversification. Your asset allocation refers to how much money you put into which types of investments, or asset classes. You might want to get really detailed and decide how much to invest in bonds, and then split that up into government bonds and corporate bonds and high-yield bonds… but that’s a lot of work, and going into that kind of detail may not improve your end result.

To keep it simple, I’m going to focus on the largest, easiest-to-buy components. This is also a very good compromise that should give you good returns going forward without putting yourself at risk of “over-fitting” by trying to fine-tune your allocation to dozens of sub-sectors, in amounts that ultimately are not likely to be meaningful.

Emergency fund: Some money kept in a savings account or cashable GIC that you can get to in short order if needed [34]. You can combine this with saving for specific near-term purchases (like new appliances, cars, or vacations), as long as you have a reserve for emergencies [35] like getting sick, losing your job, etc. There should be enough available to you on short notice to pay for a few months of rent/mortgage/utilities/etc. A good rule of thumb is three months of your essential living expenses: more, and you’re likely being too conservative and that money could be better invested in the markets; less, and you’re likely leaving yourself without a cushion.

Bonds: The more stable part of your long-term portfolio. There are lots of rules of thumb around for how much to keep in bonds: one I like is to keep a percentage equal to your age less 10 (so if you’re 20, 10% should be in bonds; at 55, 45% would be in bonds). If you have less tolerance for risk, you should have more in bonds. If you’re more comfortable with the risk of stocks, you could have less, though I would suggest always keeping at least 5-10% in bonds. As you get closer to retirement, any money you anticipate needing for the next 5-10 years should be in bonds, with longer-term savings kept in stocks. Rules of thumb like this will help you automatically rebalance towards bonds as you age. You can modify the rule for your risk tolerance (go with just your age in bonds if you have less risk tolerance, or even your age plus some percent).

Stocks: There are many ways to create diversified collections of stocks to invest in. One of the simplest is to create geographical baskets: Canadian stocks, US stocks, and international stocks. For your total stock allocation (whatever is left after bonds), it’s ok to have a bit of a home-country bias. Even though Canada is just a small part of the world economy, I’d suggest going with a pretty much even split between the three main areas.

The reason for having a bit of home country bias are taxes and currency: there’s no good reason to suspect that – over the long term – one currency or another will do better, but there will be fluctuations in relative value. Because you’ll most likely be retiring in Canada, it makes sense to keep a large part of your assets in Canadian dollars (and hence, Canadian companies) to protect against any increases in our dollar, which is what you will use to pay for many of your needs. Also, the government encourages people to invest their money in companies that underlie the economy (and employ Canadians), so investing in Canadian companies is usually a bit more tax-efficient than investing in foreign ones.

However, Canada’s economy is fairly small by global standards, so it also makes sense to have a large allocation to the US (our largest trading partner and also one of the largest stock markets) and the other developed nations around the world. Many goods are priced in global markets and the price merely converted to Canadian dollars in the stores for you, so you should likely have some holdings that are exposed to these global markets. Exactly how to split up your asset allocation is up to you, but an even 3-way split between Canada, the US, and the rest of the world is a good starting point – and like much of this book, getting close enough and making it easy is better than spending the time and effort to try to perfect it down to the last percentage point. We’ll go into more detail on how to do this in the Putting It Into Practice section.

 

Footnotes:

34: For more risk-tolerant investors you can invest your emergency fund, especially if it's for "true" emergencies and not just periodic spending. Be sure to have a buffer in that case, as you may find markets are down when you need to withdraw for an emergency.

35: That means not draining your emergency fund for non-emergency purchases – if you have $5,000 set aside for emergencies and are also saving $10,000 for a new car in your savings account, don’t go and buy the car as soon as the account hits $10,000. Keep that $5,000 (or at least some cushion) for actual emergencies, as per the plan. The car can wait until the savings account hits the full $15,000.