Last week I penned the first article on the ETF Model Portfolio section on Cut The Crap Investing. Over the next few weeks, I will write a post covering the assets and risk and return potential for each of the portfolios. I will also cover how some of the professional money managers will approach each investment model.
We’ll start with the core Balanced Portfolio models. Of course the word ‘Balanced’ communicates that there will be a mix of stocks (companies) and bonds. Remember the stocks and bonds work as a team, The Stocks are the Unruly Kids, Bonds are the Adult in the Room. The bonds are there to keep those stocks in check.
The Balanced Portfolio With More Bonds.
Once again we see those core portfolio building blocks of Canadian companies, US companies, International companies (developed markets) and those Canadians bonds.
This is the most conservative portfolio listed on the site, with 60% bonds. Once again those bonds have the potential to work like shock absorbers in major or modest stock market corrections when your portfolio might drop in value. Typically the more bonds in the portfolio, the less risk or volatility. Here’s a look at those stocks and bonds in the last major market correction, the Financial Crisis of 2007 – 2009. The developed stock markets of the world fell in the range of 45% – 55%.
From January of 2007 to end of September 2018, here’s the bond component (XBB) as Portfolio 1. Portfolio 2 is the TSX 60 (XIU). The chart is courtesy of portfoliovisualizer.com, a wonderful and very robust tool for portfolio modelling and evaluation. And for my many friends who work in compliance, past performance does not guarantee future returns.
And it looks like we have that colour coding in order. We see that rough ride of the Canadian stocks in red, while those bonds in blue are the picture of calm and composure (remember that adult reference?). If you look more closely, you’ll also see that in times of greater market stress such as in 2008 and 2015 we see the bonds spiking up in price or value as the stocks are really in ‘the tank’. Bonds have potential to go up, while stocks go down – think teeter totter. Yes investing is that simple that it can be reduced to kids and adults, shock absorbers and teeter totters. It’s certain ‘types’ of bonds that typically provide that inverse relationship to stocks – the longer dated bonds. When we’re holding the bond universe the fund includes bonds of many types, including those longer dated government and corporate bonds.
Put these two in a portfolio mix of 60% bonds and 40% stocks and the chart will look like this. That portfolio decreased in value in its worst days and weeks by 16.5%. A portfolio that also included the core assets of US stocks and International stocks would have been down ‘a little bit more’ as those assets fell a little harder than the Canadian stocks.
And there’s the rub, you would only invest in this portfolio if you were ‘comfortable’ with the potential of your portfolio falling in value by 15% – 20%. In a minor correction it might only fall by 5% or less. In the Canadian market correction of 2015, this portfolio mix was down by 6%. As always no one knows when the next correction is coming, nor how severe it might be. But we are always prepared. As our friends at Mawer write …
You Don’t Fix A Ship In a Hurricane.
The most important aspect of investing that will determine your success (or failure) is to pay attention to your risk tolerance level. We have to invest within our risk tolerance level. We have to know our risk tolerance level, or at least take a very good guess at what might be our risk tolerance level. If we’re new to investing, we don’t know. But think of it as a ‘feeling’. How would you feel if your $100,000 became $50,000? How would you feel if you had to watch your $100,000 fall to $80,000 in value? Where is your comfort level?
We have to accept the appropriate level of risk for the potential of those greater gains that go well beyond what we might earn in savings accounts and GICs. It is a risk / return proposition. And it can be life changing to understand and accept the risks that allow for that incredible wealth building.
The above conservative Balanced Portfolio With More Bonds would have earned about 5.2% per year CAGR (Compound Annual Growth Rate) from 2007 to present. That’s quite ‘good’ considering that the period includes the greatest stock market correction of our lifetime. For the Balanced With More Bonds Model, the largest portfolio decline from top to bottom was 18% from June of 2008 through to February of 2009. The portfolio recovered in November of 2009, it was under water for 18 months.
When we have portfolios the ‘go down less’ they typically can recover much more quickly. Recovery period is an important consideration when we are trying to determine our risk tolerance level. The risk return proposition might be framed as are you comfortable with a potential 18% decline for the potential of making 5% or more a year? Interestingly, this is how the popular Canadian Robo Advisor Wealthsimple will frame the risk and return proposition. Potential gains vs potential declines. BMO SmartFolio’s risk evaluation will ask you how those declines would make you feel.
PLAYING AROUND THE EDGES
Of course, being a self-directed investor you can choose to add a greater percentage of bonds for more support. The Tangerine Balanced Income Portfolio is 70% bonds and 30% stocks.
You might take the route of many of the Chief Financial Officers at the Canadian Robo Advisor and add foreign bonds, US Bonds and higher yielding bonds. We can add more complexity and perhaps a greater potential benefit. I am a big fan of simplicity, but I’ll leave that up to you. I have simply added a little more income to my personal portfolios by shading in the Canadian Hybrid bond ETF (XHB) from iShares. The trailing 12 month yield on that fund is 4.4%. But like most bond funds, the yield has been falling. This is the environment that we live in for income investors and for the income component of our portfolios. On Seeking Alpha I wrote an article that suggested My Bonds Stink. We have to reminder ourselves that the bonds are there as shock absorbers. It’s team work – stocks and bonds. The stocks have been there doing ‘their growth thing’, the bonds are more of an insurance policy. When we are constructing portfolios it’s not a bad idea to occasionally take a look at some of those charts from the 2008-2009.
And certainly with a recent boost in savings and GIC rates some investors will leave their bonds behind and go the guaranteed income route for the income component. That’s a rational choice and certainly a personal decision. This from ratehub.ca …
Always remember, that if you don’t know what you’re doing, don’t do it. There are many sensible low fee managed portfolio options from a fee-for-service advisor to the Canadian Robo Advisors.
Thanks for reading.
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