I’ve posted several times previously about my investment portfolio, but I thought I’d update regarding a few tweaks I’ve made in the last year. The main inspiration for the tweaks comes from reading Rick Ferri’s book All About Asset Allocation — I finally found a book that laid out the main aspects of portfolio selection in a thorough way, with enough graphs and correlation coefficients to satisfy my inner mathematics geek.
Here’s a table comparing last year’s portfolio target with my current target:
|
|
Weight
(last year) |
Weight
(now) |
| Equities |
| U.S.A. |
VTI |
30.1% |
28.7% |
| Europe / Pacific |
VEA |
28.7% |
26.4% |
| Emerging |
VWO |
5.2% |
8.9% |
| Canada |
XIC |
16.0% |
16.0% |
| Subtotal |
|
80% |
80% |
|
| Fixed income |
| Short bonds |
XSB |
15.0% |
|
| Broad bonds |
XBB/VAB |
|
11.3% |
| Real return bonds |
XRB |
|
3.8% |
| Subtotal |
|
15% |
15% |
|
| Cash |
|
5% |
5% |
Equities
I took a more careful approach to splitting equities up across the regions of the world. The weights are based on the total market capitalization of the stock markets in each region (rather than “GDP weighted”) as of Oct. 2011, with an adjustment to force Canada to 20% of the equity portfolio. As can be seen, the emerging markets are the main item that changed in this review, mostly because different sources list different countries in the “emerging” category, and because emerging markets have gained quite a bit against developed markets since I first put my targets together several years ago.
(Side note: there’s also now a nice VXUS Vanguard fund covering VEA, VWO and some XIC, with better small-cap exposure and reasonable fees. Definitely a nice way to keep the VEA/VWO balanced for less effort.)
Fixed income
Ferri’s book helped me understand bonds better, and how stocks and bonds interact in a portfolio. I’d read advice that “long bonds have poorer returns that stocks over the long term, and therefore you should own stocks for high risk/high return and short-term bonds for safety.” On that basis, I’d bought XSB (a short-term bond index, average duration of about 2.9 years).
Medium- and long-term bonds are also quite “safe” (over an investment horizon of several years). They also typically offer better returns than short-term bonds. One source I read described short-term bonds as helpful in “inflationary recessions” and long-term bonds as helpful in “deflationary recessions.” Regardless, I’ve seen little evidence to favour short-term bonds over the other types. As a result, I’ve shifted to XBB (or VAB) which contains a mix of short, medium and long-term bonds, all investment grade.
More importantly, I now understand how stocks and bonds interact. In technical language, they have low correlation, but I find there’s an easier way to think about it. When you hold both stocks and bonds and rebalance at the end of each year, you’re essentially using the “low correlation” as a way to sell high/buy low. If it’s a great year for stocks, it’s usually a poor year for bonds. Rebalancing will require you to sell stocks at the end of the year (“sell high”) and shift money into bonds (“buy low”). It’s a really simple way to force you into this strategy. Additionally, stocks and bonds have a good fundamental basis for being “low correlated” – they are really different ways of providing capital to a company. Stocks are “high risk” ownership where stockholders take on the risk of good/bad economies, good/bad company performance etc. Bonds are “low risk” loans where bondholders receive income regardless of the economy or company performance; the main risk that bondholders retain is interest rate risk (that is, the risk that they could have asked for more interest on their loans if they’d loaned at a later date). These two different types of retained-risk fundamentally drive the low correlation, and make stocks and bonds much more distinct than, say, two stocks from different industries.
I also find that this “buy low / sell high” understanding of stocks/bonds helps me decide how to make changes to my portfolio targets. For example, given the past year of poor stock performance and good bond performance, it’s a poor time to change the stock/bond allocation in my portfolio from 80%/15% to 75%/20% because that would mean “selling stocks low” and “buying bonds high.” Instead, if I want to make that change, I’ll wait a year or two.
Finally, I’ve also added “real return bonds” to the portfolio – as I understand it, they are very similar to the “broad bonds,” but with a different mix of interest-rate vs. inflation risk. I’ll admit my understanding remains a little fuzzy.
Cash
I keep most of my cash in the bank to avoid transaction fees. However, I’ve seen some portfolios where short-term bond ETFs are treated as cash – after all, they’re very safe and liquid instruments with a healthy 3-4% annual return.
Small-caps and Value
I learned a little about the Fama/French finding – that small-cap companies and “value-oriented” companies have historically offered higher returns than the overall stock market. I considered buying some ETFs for this purpose, but ultimately held back. My take is that the Fama/French findings are very well-known now, and that it’s not clear that a premium will continue to exist. Tilting the portfolio in that direction is essentially a “bet” on an ongoing premium.
Instead, my equity investment goal is simply to reproduce the performance of the global equity market, weighted by market capitalization. No ifs, ands or buts; and no addition of extra layers of “bets.” I’ll continue to aim to get coverage of small-caps and micro-caps in my portfolio, but I won’t give them extra weight as a Fama/French bet.
Performance
And now, a quick detour into the performance of this portfolio over the past several years. The table below shows the annual returns of each component of the portfolio, giving the “sequence of returns” for each piece.
|
|
2007 |
2008 |
2009 |
2010 |
2011 |
| Equities |
| U.S.A. |
VTI |
-9% |
-23% |
11% |
11% |
6% |
| Europe / Pacific |
VEA |
-6% |
-27% |
10% |
3% |
-8% |
| Emerging |
VWO |
17% |
-42% |
52% |
13% |
-15% |
| Canada |
XIC |
9% |
-33% |
34% |
17% |
-9% |
| Subtotal |
|
-1.6% |
-28.3% |
19.8% |
9.9% |
-3.9% |
|
| Fixed income |
| Mixed bonds |
XBB/VAB |
3% |
6% |
5% |
6% |
9% |
| Real return bonds |
XRB |
1% |
0% |
14% |
10% |
18% |
| Subtotal |
|
2.5% |
4.6% |
7.4% |
7.1% |
11.4% |
|
| Cash |
|
0% |
0% |
0% |
0% |
0% |
| Total |
|
-0.9% |
-22.0% |
16.9% |
9.0% |
-1.4% |
Assumptions:
- Expressed in Canadian dollar terms (i.e., including all currency shift effects and using no currency hedging)
- Rebalanced annually
Cumulative returns:
- From Jan. 2007 to Dec. 2011: -2.9%
- From Jan. 2008 to Dec. 2011: -2.0%
- From Jan. 2009 to Dec. 2011: 25.6%
- From Jan. 2010 to Dec. 2011: 7.4%
I started investing in late 2008, so I usually look at the Jan. 2009 – Dec 2011 return – but it’s always good to remember that this gives a very rosy view compared to other starting dates.
Closing Thoughts
Sure, it’s been a poor year – the European crisis hit stocks hard – but the impact on the whole portfolio was still not huge. I’m feeling steadily more comfortable with investment, thanks to a few years of watching the markets closely and really trying to understand what’s happening. I can’t predict the ups and downs, but at least I’ve done my homework.
A more electronic-heavy mix, to celebrate the start of my summer break!