Choosing your asset allocation

The temptation exists for investors to immediately start choosing individual stocks, bonds, mutual funds or ETFs (exchange traded funds) for their portfolios. In fact, this is where many investors start.

They may have heard of a promising stock or scoured the financial pages for a top performing mutual fund. Unfortunately, they are investing without a plan and without taking into account the principles of building a suitable portfolio.

Actually, this approach is closer to speculating than investing, even if the investment chosen is not particularly aggressive.

The next step should be to determine the proper balance of investments in your account; in other words, it should be to determine the appropriate allocation among the various asset classes.

The Proper Balance

The analogy of a balanced diet can be revisited. Everyone needs protein, carbs, fats, vitamins and minerals; it is just that at different stages of our life, the balance among them should differ. The same applies to building a portfolio. The investment assets need to be allocated properly to suit the needs of the individual client. How much, if any, should be allocated to equities, to fixed income or to gold?

If you have completed a risk tolerance (investment profile) questionnaire, you will already know whether you are more conservative, equally conservative, or more aggressive than the average investor. Even with that information in hand, translating it into a suitable asset allocation is the next challenge.

One may think an investment in shares of a Canadian bank is a conservative investment, while others think a five year GIC is aggressive. Both would be wrong. Guidelines are needed to allow you to build the portfolio that matches your needs.

Most questionnaires not only provide the investor with a profile, they will suggest an asset allocation that fits with the profile. Even if the questionnaire does not generate any suggestions for asset allocation, you can seek the advice of a financial advisor to interpret that information and provide you with recommendations.

Asset Allocation - Rule of Thumb

Previously, I mentioned that a rule of thumb which is often used to determine a basic asset allocation is the age factor. It is worth reviewing.

Using this rule of thumb, the investor’s age would equal the percentage of the portfolio allocated to bonds (fixed income) in a simply constructed portfolio. A 40 year old would have a portfolio that has an allocation of 40% in bonds, while a 60 year old would have an allocation of 60% in bonds.

Using this rule of thumb, the investor would then allocate the remainder of the portfolio to equities. While this portfolio would contain only two asset classes it would still represent a basic level of diversification.

Investors who felt they were more conservative than average would have an allocation to bonds that was higher than their age. Conversely, a more aggressive investor would have an allocation to bonds that was lower than their age. Using this approach, investors must determine whether they are more conservative, more aggressive or about average.

It is a simplistic method to determine asset allocation and certainly better than randomly selecting investments regardless of asset class. For investors who have never paid attention to asset allocation, it can be a quick way to check their portfolio.

Although it is better than nothing, one shortcoming with that rule of thumb is that it doesn’t provide any guidance on how much should be allocated to the other asset classes. It only suggests a mix between fixed income and equities. The questionnaire that you use should provide more specific guidelines.

Sometimes, less is more. The categorization of six asset classes allows for a more clearly defined big picture than trying to incorporate fifteen or more asset classes. At a glance, you can determine if your mix of assets is reasonable. From there you can examine the investments within each asset class, knowing that the big picture is where it should be.

Once you are comfortable with your asset allocation decision, volatility can be further squeezed out of a portfolio by prudent investment decisions within each asset class. Careful selection of the pecific investments can also improve your chances of increasing the return on your overall portfolio.

Risk Adjusted Returns

Investopedia ( defines risk adjusted returns as “a concept that refines an investment’s return by measuring how much risk is involved in producing that return”.

Generally speaking, risk is considered to be the amount of volatility associated with a given investment and various statistical measures can be used to measure that volatility.

It is important to remember that adding value doesn’t mean achieving better returns; it means achieving better risk-adjusted returns. If two investments have identical long term rates of return but the first is highly volatile while the second is relatively stable, then the second investment has better risk-adjusted returns.

You can count on the second investment to meet your expectations much more consistently than you can count on the first.

When comparing the performance numbers of any investments, consider the volatility along with the performance. The following chart illustrates the risk and return characteristics of a variety of investments. A higher position on the chart indicates a better return; the farther right the position, the greater the risk (volatility) of the investment. The trend line indicates a reasonable return for the amount of risk within the investment.



Those investments that fall above the line have a superior risk/return profile than those that fall below the line.

The risk return profile for most investments can be plotted on a chart to help you visualize those investments that have done well and those whose performance has not justified the amount of risk to which you have been exposed.


Even investors who take a passive approach to their asset allocation will see that allocation drifts away from your starting point (the baseline) over time. Asset classes all grow at different rates and, left untouched, a portfolio will become skewed toward the best performing asset class and away from the poorest performing asset class.

Approximately once a year, or when new cash is added to a portfolio, the asset allocation should be reviewed to ensure that it is still close to the baseline. Another instance of when rebalancing should occur is when there has been a significant move in one or more of the asset classes.

There should always be some leeway from your ideal asset mix or you would be constantly rebalancing and have time in your life for little else.

A side effect of rebalancing is that it forces the investor to sell a portion of their investments at a high price (the best performers) and replace them with low priced assets (those that have had the poorest performance). It is a strategy of selling high and buying low. This investment discipline helps to moderate volatility and can improve returns over time.


The best approach is to complete a risk tolerance questionnaire that suggests an appropriate asset mix. Failing that, some general guidelines using only three asset classes and three investment profiles can help to point you in the right direction.

Keep in mind that these asset mixes don’t make any allowance for age or many other factors. They simply serve as a starting point from which you, or your advisor, can begin to formulate an appropriate asset mix.


  • An inverted yield curve is the situation that occurs when short term interest rates are higher than long term rates. An economic recession often follows when the situation of an inverted yield curve occurs.
  • Long term bonds fluctuate in value more than short term bonds.
  • While it seems counter intuitive, bond prices fall when interest rates rise and bond prices rise when interest rates fall.
  • The total return on a bond is comprised of the interest plus or minus the change in price, if any.
  • Preferred shares are more closely related to bonds than to common shares.
  • The benchmark for the Canadian stock market (S&P/TSX Composite Index) does not include preferred shares and has only recently added real estate investment trusts.
  • The average value of the stock market over the past 110 years has been about 16x the average annual earnings. The ratio is known as the PE ratio.
  • The PE ratio has been below 10x and above 40x on several occasions.
  • Investor psychology/expectations result in valuations that are far different from the long term averages.
  • Equities have tended to go through long periods of above average growth, known as secular bull markets, followed by long periods of below average growth, known as secular bear markets.
  • These secular trends can last for 10 to 15 years or more.
  • REITs allow for participation in a wide variety of real estate holdings.
  • The value of REITs can be affected by mortgage rates, rental or lease rates and occupancy rates.
  • Gold has several features that make it attractive as a currency.
  • When interest rates are below the level of inflation, gold becomes an attractive alternative to paper currencies.
  • Hyperinflation describes periods of extreme inflation where the purchasing power of a currency erodes quickly and can be a result of a government printing more money than is justified by the growth in its economy.
  • Many categories of mutual funds achieved excellent returns during the economic downturn from 2008 to 2012.
  • Calculating risk adjusted returns involves taking the volatility of the investment into consideration.
  • Segregated funds can be useful as an estate planning tool.
  • Choosing the appropriate asset allocation is the key first step to investment success; choosing specific investments within those asset classes is the second step.
  • The historical risk/return profile of individual investments can be measured and plotted on a chart to provide a visual reference.
  • Rebalancing is the process that returns the investments within your portfolio back to the desired asset allocation when it begins to deviate from your original strategy.

NEXT: Caution - Questionable Investments