Tuesday, May 20, 2014

A Radical Idea about Asset Allocation for Novice Investors

There is no shortage of advice out there on how to find the right balance between the asset allocation that makes people comfortable (low volatility, but low return), and the asset allocation that makes people money (high return, but high volatility). I’m going to suggest a possible different approach for novice investors.

Disclaimer: I do not recommend the following strategy in any way. These are just ideas to chew on. Think for yourself.

Because high returns and high volatility go hand-in-hand, we’re advised to seek the most risk we can handle while still able to stick to an investment plan and sleep well at night. The most nervous investors end up with low returns either because they have few risky investments or because they bail out of their risky investments at the worst possible time.

Even not so nervous investors can have these types of problems. Toss in some unreasonably high mutual fund MERs, and the end result is that their long-term savings grow to less than half of their potential by the time they retire. What if novice investors were to work on their tolerance for volatility when they’re young?

Imagine a 20-something, Dan, who just started a new full-time job and is still living at home. Dan starts saving 20% of his take-home pay in an RRSP or TFSA as long-term savings. He also saves money in a savings account for short-term desires, such as first and last month’s rent for when he moves out, a used car, and extra payments against his student loan.

What if Dan ignored all the asset allocation advice and just invested all his long-term savings in a Canadian stock exchange-traded fund (ETF) such as VCN or XIU? In addition to seeking the high returns from stocks, Dan would be seeking experience with stock volatility. He’ll have lots of time to change his asset allocation once his savings grow to $25,000 or $50,000.

We could even teach Dan to cheer every time his ETF dropped in price because he knows he’ll be able to buy even more units with his savings. With any luck, Dan would experience at least one significant drop in stocks prices in the few years it takes him to build up $25,000 or $50,000. This might help him calmly choose a higher-reward asset allocation for the long term and comfortably ride out the inevitable downturns over the decades.

Humans are adaptable, especially when they are young. Instead of treating our tolerance for risk as a fixed trait we carry around for our whole lives, what if we tried to teach young people to build a greater tolerance for uneven portfolio returns and stay focused on long-term goals with any savings designated for the long term?

14 comments:

  1. I'm more inclined to slowly ease into the pool rather than dive in. I think few things are more discouraging to a new investor than a significant loss. If Dan was diligently putting 20% of his money away in only a Canadian stock ETF and the markets took a dive, that might make him more risk averse not less. Might be an idea to just start with a more traditional 60/40 mix and let Dan see the value of diversification and rebalancing, how different asset classes can smooth out the bumps, etc. Then again, I'm pretty cautious, likely too much so at times, and I do appreciate your point that an investor needs to embrace volatility to earn maximum returns.

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    1. @Juan: I've certainly seen investors who got discouraged, but they were people who came into some money (usually a modest inheritance) and were ill-prepared for stock market volatility. My hope is that a young person starting with no savings and slowly building them up might be able to learn to be sanguine about stock volatility. I fear that playing it safe from a young age will just lead to playing it too safe for a lifetime.

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  2. Hi Michael,I agree that the getting exposed to the vagaries of the stock market early on is a good idea. Also, a simple approach like that makes things easy for a novice. The risk is limited in the long run, because it is unlikely that the market remains permanently depressed.

    The main issue I have with that approach is that the voluntary restriction to the Canadian stock market foregoes a lot of growth and risk mitigation potential. Canada is just one country, after all. Also, our industry mix is rather narrow. Wouldn't it make more sense, if such a simple approach (one holding, stocks only) were to be followed, to invest in a global equity ETF like XWD?

    Alternatively (to float a heretical idea), why not go after the S&P 500 and ditch the Canadian equity market altogether? Yes, tax is an issue for distributions, but the industry mix and the global diversification (due to foreign activities of the underlying companies) is much broader.

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    1. @Holger: I wanted to keep things simple by keeping U.S. dollars out of it to start. I don't think asset allocation is all that important while a portfolio is very small. However, I agree that including U.S. and foreign stocks is a good idea for the long run.

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  3. I've got a bit of the same kind of thinking in terms of mutual funds vs ETFs and other things that require discount brokerages: it's better to start with ETFs and get an idea of how things work, and maybe even make mistakes, to gain a better understanding of how things works, so that when real money is at stake it isn't as worrisome.

    For example, I made a few mistakes in my first ETF purchases: buying them at night and then getting a raw deal when the price at open was clearly higher, but that was with 2500$ at stake, so a minor price difference, or any other likely mistake, had a very, very minor impact. I see other people start looking at ETFs when they have 6-figure portfolios and they can't start actually doing anything, it's too intimidating.

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    1. @Anonymous: You make an interesting point. I certainly made some mistakes in my early days of making trades in my discount brokerage account.

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  4. I've looked at another related approach of considering different "buckets" in the portfolio. If someone wanted to retire with a $1m portfolio that was 60% in stocks, they could start buying the stocks first and only buy bonds once they reached $600,000. This doesn't necessarily lead to good behavior but it does maximize the benefits of time. There are a lot of cases like this where the asset allocation doesn't need to match a perfect percentage all the time.

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    1. @Richard: That's an interesting idea. If you want a 60/40 split because you don't want to have to handle too much volatility, I think your approach might be hard to handle once your portfolio gets into 6 figures of all stocks. But, if your reason for wanting 60/40 is to control volatility before heading into retirement, this strategy could work.

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  5. This is a great idea and something I wish I'd done for myself.

    I've just recently changed my RRSP into self directed and am experimenting with all kinds of things. If only it was several years ago when I was more willing to try things and then I'd kiss the bonds goodbye for just a few years.

    I'm still figuring things out.
    Ron B

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    1. @Ron: It's normal for starting investors to try different things. However, many investors tinker with their asset allocations frequently in a way that amounts to performance chasing. They don't think they're doing this, but somehow their choices always lead to selling what's low and buying what's high. While you continue to figure things out, think about whether your actions amount to performance chasing.

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    2. I still would like to go for the smartest thing in the long run so doing what Richard suggests above may be the way to go.
      Ron B

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    3. I'm still trying to wrap my head around if I have bonds in my RRSP than I don't necessarily need them in my TFSA too. Argh.

      In your opinion (I've read a few others online) should I treat my accounts as one large portfolio or is it better to treat them individually?

      I realize certain things should not be in a TFSA and a taxable account, etc so I'm thinking it would be better to treat all my accounts as one portfolio.

      Thoughts? Thanks in advance.
      Ron B

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    4. @Ron: My wife and I have several accounts each and I treat it as one large portfolio. However, some people prefer to balance each account. I like having the ability to keep all my U.S. stocks in RRSP accounts to avoid withholding taxes.

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    5. Thanks, Michael.

      Time to dump my accounts into a spreadsheet and see what's what. No U.S. stocks for me yet but I do have some bonds in my RRSP and my TFSA so there may be a bit too much of that. Hmm.

      Ron B

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