Investing is full of lingo and buzzwords. It’s similar to sailing, a pastime that has developed its own vocabulary which, if you’re new to sailing, makes you feel like you don’t belong on a sailboat. Likewise, investing talk can make one feel like it’s beyond their realm of understanding.
There are too many buzzwords in the investing world. The truth is though that most of them are completely unnecessary. You do not need to know them to understand investing and more importantly, get your money invested.
There are, however, a few terms that you should know. Terms that are actually important. One of them is asset allocation. Like lazarette – a compartment on a sailboat to store stuff – it’s a fancy word with a simple meaning.
Asset allocation is simply how you divide up your money between different types of investments, primarily stocks, bonds and cash. Asset allocation is the most important decision you'll make as an investor. Your allocation to different asset classes – which means “type of investment” - will impact your long-term investment returns and how much volatility your investments experience. It’s important to get it right. Fortunately, determining your asset allocation is actually pretty simple.
The most important input to your asset allocation decision is your investment time horizon. Why? Because the stock market is volatile. Even though it goes up over long time periods, it can gyrate wildly over short time periods. After a big market downturn, it can take several years to recover its value. You need to have time to grow your money because some years the market will be up 15% and in some it will be down 15%. If you invest for one year and that year happens to be a minus 15% year, well, that’s not good. But if you invest for ten years or more, your money is very likely to produce a positive return.
The second input is your tolerance for risk. Even if your time horizon is long, your ability to handle the ups and down is equally important. It’s no good to have a portfolio that makes you feel anxious – because really, don’t we have better things to worry about?
Determining your time horizon and tolerance for volatility
Generally, if you have a time horizon of more than ten years, that’s considered to be long term. A medium time horizon is five to ten years. If you’re looking to invest for less than five years, you should probably avoid the stock market and invest in something safe like GICs or a high interest savings ETF.
Tolerance for volatility is more difficult to gauge because it’s subjective. Ask yourself this question: if I looked at my investment account and saw that it had declined by 15% over a one-year period, would I want to sell my investments and get out of the market? If the answer is yes, then you have a lower tolerance for volatility. If you can tell yourself to stick it out, stop thinking about it, and wait for your investments to go back up, then your tolerance is high. If you are heavily invested in the stock market – meaning 80% or more of your account is invested in stocks – you have to be prepared for large declines like this. It doesn’t happen often, but declines of 15% or more in one year do happen. For example, in 2022 the U.S. stock market was down 18%, in 2008 it declined 38%, and in 2002 it fell by 23%. The market has always recovered – but do you have the stomach to wait it out?
Once you’ve determined these two factors, deciding on your asset allocation is actually pretty simple. There are standard allocations for different risk profiles that are well-accepted in the investment industry. One common portfolio is “the 80/20”. This means that 80% of your portfolio is invested in stocks and 20% is in bonds. The 60/40 is also common. You can find lots of examples online of asset allocation profiles. Have a look at this one from RBC – scroll down the “What type of investor are you?” section.
(An important note. “Stocks” doesn’t mean you have to buy individual stocks. You can own an ETF or a mutual fund that invests in stocks. “Bonds” doesn’t mean you have to buy an individual bond – you can own an ETF or mutual fund that invests in bonds.)
You can take an online quiz like this one which can help you determine your asset allocation.
The graphic below shows some asset allocations that are fairly standard. Note that I haven’t included cash here. You only need to keep some money in cash – like a savings account – if you think you will need it for something in the very near future. Otherwise, if you’re investing for the long term, you can put 100% of your money into stocks and bonds. You will also note that I haven’t included “low tolerance for volatility” and “short time horizon” as input factors. This is because both of those factors are indicators that the stock market isn’t the right choice. GICs, HISA ETFs and savings accounts are more appropriate.
You will see that these asset allocations are very simple. You don’t need to agonize over whether 80% or 83% is the right number – just choose some nice round numbers
There’s a second asset allocation decision you need to make: how you will divide up your stocks into Canadian stocks, U.S. stocks and international stocks. You don’t need to consider time horizon and tolerance for volatility when making this decision. You can look at some examples of geographic diversification – for example, PWL Capital uses 20% Canada, 50% US and 30% international. This is a fairly common allocation, although 30%, 40% and 30% is also a good mix. It doesn’t really matter all that much – what’s important is that you are not investing solely in Canada.
*Note: Equity means stocks, including mutual funds and exchange-traded funds that invest in stocks. Fixed income means bonds, including funds that invest in bonds. Fixed income can also include GICs.