A colleague of mine threw out a statement recently: he said most retail investors don’t really grasp the concept of a portfolio. My objection to that musing was immediate, but there is nothing quite like a controversial opinion to get a person thinking. Was my colleague correct, at least to some degree?
First of all, I believe most retail investors do understand and accept the concept of asset allocation, even if they don’t actually practice it. It is a truth universally acknowledged that a collection of securities should contain elements of cash, fixed income securities and equities, and that the proportions allocated to each of these asset classes should reflect the benevolent conflict between return objectives and risk tolerance.
The reason for allocating investment assets judiciously goes beyond the simple notion of not putting all of one’s eggs in one basket, in case that one basket goes asunder. Proper asset allocation exploits the differences in correlation of those assets, thereby reducing risk proportionately more than reducing return. If there is a free lunch in investing, this is it, though the market doesn’t pay for avoiding avoidable risk. It only charges for not avoiding avoidable risk; for example, by not allocating assets among different asset classes.
Practicing proper asset allocation appears to be another matter for retail investors. It’s also a costly one, if the stats are correct that 80% to 90% of returns are attributable to the asset mix decision alone, not market timing, not securities selection, not luck. As I noted in my most recent column, most retail portfolios have a lower fixed income allocation than what is warranted. As I also stated, my capital market expectations for the next few months indicate that retail investors would be well to correct this imbalance right away. You know you should have more bonds in your portfolio than you do? Then maybe you should fix that—now. If you accept the concept of proper asset allocation, then you should implement it.
On another note, when I dealt with retail clients on a discretionary basis, portfolio review time was always interesting. In those face-to-face meetings, clients would want to spend the first five minutes talking about what worked, and 55 minutes about what went wrong, which is understandable if not all that productive. But my colleague’s comment on clients not understanding the portfolio concept brought to mind another interesting experience in those meetings.
Suppose the client was a husband and wife team. The husband would want to talk about his cash account, and then his RRSP, as separate entities. The wife would want to do the same with her cash account and then her RRSP. Then they’d both want to talk about their joint account.
The problem is that there aren’t five portfolios here. There is one, and only one portfolio here. It may be spread across five different containers, in a way that minimizes taxes, but it’s all one portfolio.
Try this on for size. If you have 10% of your investment capital in cash in a trust company, 40% in bonds at an independent brokerage firm, and 50% in equities at a bank-owned firm, how many portfolios do you have? And, if your answer is more than one, are any or all of them improperly allocated, assuming you’re a balanced investor?
If you have a few GICs here, a TFSA there, and cash in a brokerage firm somewhere else, which of these qualify as the cash component of your portfolio? Of course they all do.
I don’t think my colleague was totally correct when he said what he did. I’m asking you to prove him wrong by assessing your true asset allocation as it stands now, and making corrections as necessary.
If you use an adviser but you also have a little discount broker account on the side that you haven’t told your adviser about, then you, like a DIY investor, are the only one that can undertake this assessment.