Proper asset allocation needs equity, fixed-income, and cash
Is now the right time to put money into stocks? After all, the S&P/TSX Composite Index is up about 15% from its low point about a year ago. But when you think about it, it’s an odd question. If you had put (or kept) $10,000 in a broad index-tracking exchange-traded fund a year ago, you’d now be ahead about $1,500. So what happened? Did you miss out on that gain, because you did not have an allocation to stocks?
So when I’m asked whether now is the right time to get into the stock market, I usually answer that anytime is the right time to get into stocks. In fact, you should always be in stocks to some extent. But here’s the important thing: You should also always be in bonds. And in cash. In other words, you should have a plan for asset allocation.
I’m talking here about proper asset allocation. Basically, this means that you determine what kind of investor you are, what your financial objectives are, and how much risk you can really withstand. Once you’ve nailed that down, then create a portfolio of investments that reflects your profile.
You might, for example, be a growth investor looking for capital gains while mitigating risk – you don’t want to speculate. In that case you’d allocate, say, 10% of your portfolio to cash, 25% to fixed income, and 65% to stocks. And you’ll stick to roughly this allocation through thick and thin. You’ll always have tilt toward equities in your portfolio, but you’ll also have bonds to help mitigate risk and provide income, while your cash gives you flexibility and a cushion against steep market selloffs.
And what if markets head south?
The plain fact about capital markets is that there is risk involved. Markets will fluctuate, sometimes drastically. No one knows exactly when that will happen or by how much. Trying to guess market tops and bottoms is called “market timing,” and no one ever gets it right, except by sheer accident.
When you have a planned asset allocation strategy that you stick to, you’ll feel more comfortable weathering the inevitable stock market downturns. Yes, the equity portion of your portfolio will plunge right along with the market. But your bond holdings are likely to soar, offsetting losses in equities. That’s called mitigating risk.
How to start
Getting started investing is easy. The nuts and bolts are simple. Open an online trading account, put a few bucks into it, and you’re an investor. But to really get started off on the right foot, you need little common sense and a few basic rules.
Don’t start with a marathon. Even before you start researching stocks, mutual funds, or ETFs as potential investments, you have to start with the basics. First, remember that there is no free lunch. If you are serious about investing, then you will need to start from ground zero and build from there. Learn the basics of the market. You don’t need to degree in higher finance. There’s plenty of good educational material online to help you become market literate. For example, the Ontario Securities Commission has an entire “Investor Resources” section with a wealth of information for novice investors.
Make it grow. Understand the power of compounding. As we’ve seen, this is the principle that any earnings from an asset will in turn generate their own earnings. Compounding allows your original investment amount to grow faster when earnings are reinvested than when earnings are paid out. Most people will have heard about “compound interest,” which is simply the principle of compounding applied to risk-free interest-bearing assets, like Guaranteed Investment Certificates and those so-called “savings” accounts, where the interest earns interest. Apply it to an investment portfolio and the compounding machine really goes to work.
Cut taxes. This is perhaps the most important rule of all, because tax efficiency accounts for a large chunk of investment return – as much as 28% according to research. So make full use of tax-free, tax-deferred, and tax-efficient investment plans and products. It’s what I call the “The Wealth Effect.” While the type of securities you hold (asset mix) and the choice of securities (security selection) are important, tax-efficiency is absolutely critical for building wealth, and it’s the one element over which you have the most control.
The bottom line is that you should have allocations to stocks, bonds, and cash at all times, instead of switching in and out of assets at random based on the headline of the day. It’s a matter of degree – allocating your asset mix according to your objectives and tolerance for risk. The market hits a record high? It plunges 10%? So what? Investing is a long-term business, and you’ll have a much greater chance of success in the long term if you have a plan…and stick to it.