Asset Allocation - What's That and Why Should We Care?

Finance research says that 90+% of portfolio return is attributable to asset allocation. Wikipedia has a useful entry on asset allocation that outlines some of the studies and issues. What does that mean in terms of what I should do as an investor?

The first step is to define terms. What is an asset? Almost every source skirts the issue and immediately begins discussing stocks and bonds as if the answer is self-evident. This makes me suspicious. Defining beauty as being in the eye of the beholder is fine for endeavours where judgement and qualitative judgements are acceptable but this is not the case in finance where fact-based reasoning is the basis for good decisions (though perhaps not the complete answer). One place that provides a definition of asset is Duke University finance prof Campbell Harvey's website. His definition is short and simple: "Any possession that has value in an exchange." The definition for exchange says that means places like the NYSE, NASDAQ, which trade stocks, bonds, commodities and indexes. In turn, therefore, the implication is that it is only those types of possessions that can be considered assets. Isn't this definition too restrictive? One enormously important possession which constitutes a considerable part of most individual investor's net worth, myself included, is my house. Many have cottages too. Then there are other kinds of possessions that many consider to be investments, such as fine art, antiques, coins, rare wines, even hockey memorabilia. At one time long ago, I believe tulip bulbs were a popular investment asset!

I suspect that such a restrictive definition, implicit in many investing tools, websites, books etc, where the choices discussed are limited to stocks and bonds, arises for a couple of reasons: first, availability of data that can be directly comparable and computed into portfolios in a risk-return relationship; second, the comfort zone and asset area familiarity of the advice giver, or maybe, to look at it more cynically, what the advice giver has to sell. Yet, out here in the real world, we individual investors deal with everything tangible and intangible that we can buy and sell. Such a broader definition of asset is provided by various sources such as Answers.com: "A resource having economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit." In real life, we ask ourselves whether it is better financially to buy a cottage or invest in the stock market, so we need a financial structure to do that, recognizing of course, that not all such investment decisions are purely financial matters. The onus is on those who would exclude the broadest possible definition of asset.

I believe there is a critically important positive reason to factor in a broad range of assets and that has to do with risk reduction and diversification. Diversification only works in reducing risk if the various investments do not move in tandem. In technical terms, moving in tandem is expressed as a correlation coefficient, a statistical measure that moves between +1 and -1. At +1, two investments move exactly together all the time. There is no risk reduction at all from combining such assets. With 0 (zero) correlation, they do not move at all together but in random fashion relative to each other. The other extreme of -1 correlation is when one moves up, the other moves down. This is, in fact, the best situation since risk can almost entirely be eliminated. (It does not mean however, that there are no overall returns - that the negative return cancels out the positive and the investor is left with no net gain.) A very good explanation of how this works with simple examples to illustrate what I've just said is here at the website of TIAA-CREF.

So, the principle I draw from all the above is that assets and the choice of assets need to be defined functionally in terms of correlations amongst each other in anticipation of being combined into a portfolio with the highest return for the least risk. And to adopt a broad definition of portfolio, I think the appropriate definition is the combination of everything I own that can be sold, not just those pieces that sit in my brokerage account.

This isn't the end of the story on asset allocation. Next, for a future post, is the question of which assets have which type of correlation.

iShares Distribution Reinvestment vs DRIP

A follow-on to yesterday's post about Exchange Traded Funds (ETFs) is another perhaps confusing characteristic regarding distributions and reinvestments. As the blue highlighted area of this table shows for the Canadian iShares ETFs, in 2006 there were both cash distributions and reinvested distributions paid on a number of the ETFs. The cash distributions are actually paid out to the owners of each ETF at the end of each quarter just like dividends of any other company stock (with shareholders of record date for eligibility etc). An iShares press release gives the amounts for the 2007 March end quarter. For buy and hold investors like me, I don't need the cash/dividend to pay everyday expenses and I would rather that all the money be reinvested with the least cost and effort. Unlike many companies which have Dividend Reinvestment Programs (DRIP) that allow any dividends paid out to be automatically used to buy extra shares without brokerage fees, iShares cannot do so itself with its cash distributions as it explains on this FAQ page, though it says that brokers might provide the service (and it seems that Canadian ShareOwner Investment Inc is one that will but mine - BMO Investorline - will not ... hint, hint).

Stingy Investor has a very handy page listing all the Canadian companies with DRIPs (and related things like Stock Purchase Plans) for those who are interested.

Excellent Personal Financial Planning Primer

The Financial Webring is already bookmarked on the right hand side of this blog as a discussion forum but I've discovered it also has a fine brief primer on personal financial planning. The advice is direct, understandable and sensible. It covers all the main areas one needs to be concerned with, namely:

• Day to day finances (budgeting, expense control, mortgages, other debt, emergency funds, etc.)
  
• Insurance (life, health, disability, property)
  
• Taxes (exemptions, deferrals, income splitting)
  
• Investments (asset allocation, security selection, risk management)
  
• Retirement (pensions, RRSPs, RRIFs, annuities, etc.)
  
• Estate (wills, powers of attorney, use of trusts, planned giving, etc.)

There are very useful links to further reading. Like everyone, there are areas in which I am fairly knowledgeable and others where I can use some improvement so the page is a good launching point for further investigation into those weak areas.

Adjusted Cost Base for ETFs and Mutual Funds

I'm doing my taxes these days and part of that is to report the gain on some iShares Exchange Traded Funds (ETFs) that I sold in 2006. There's a tricky bit involved in that process which I figure is worth noting in case anyone might end up paying tax twice on their gains. Though mutual funds and ETFs are substantially similar in that they pass through capital gains and income to unit owners, there is a particular and important difference when it comes to the reinvestment of distributions. In mutual funds, the reinvestments show up as additional units and a higher adjusted cost base (ACB) for those units but with ETFs they do not. You must keep track yourself of the reinvestments and the higher ACB for ETFs. Otherwise, if you just take your original purchase cost for the ETF as the ACB, you will end paying tax again on the reinvested distribution that you already pay each year when taking figures from the T slips. I know my discount broker BMO Investorline does not keep track of the higher ACB when it shows my cost in account listings or statements. Probably none of the discount brokers do and I'm not sure all full service brokers do. It's worth checking. The iShares website has a good FAQ on the subject with more detail and a side-by-side example of the ETF vs mutual fund method. Here is another good explanation how this works for mutual funds from McColl Turner Chartered Accountants. Update January 14, 2008: Note that a return of capital distribution reduces the cost of an ETF and it is necessary for an individual investor to subtract it to properly track ACB. The proper formula for ACB, as explained by Howard Atkinson on page 160 of his excellent book on ETFs, The New Investment Frontier III, is: ACB = (total purchases + acquisition costs + reinvested distributions - return of capital) / units purchased. The main iShares page has a link labeled iShares CDN Funds - 2006 Tax Characteristics which shows all the iShares Canadian ETFs and their reinvested distributions; for earlier year breakdowns, go into the individual fund info and look for the Distribution History link on the left hand side e.g. this page for the Energy sector XEG fund.

I have to admit that despite my general preference for ETFs, this is an advantage of mutual funds over ETFs in the calculation convenience and the avoidance of costly oversights. Over a long holding period this can be significant. Even in the short space of two years from 2004 to 2006, the iShares TSX 60 XIU that I sold increased by almost $3 per unit in ACB. I'd be paying our friends at CRA quite a bit more if I simply used the original purchase cost.

Book Review: Buying Time by Daryl Diamond

The "buying time" title refers to spending more money early in retirement to have fun and not end up with a big pile of money kept aside for fear of running out with regrets for all the things that never got done in retirement. The subtitle of this book describes better what it is about: "Trading your savings for income and lifestyle in your prime retirement years". The author is a professional retirement planner with his own website.

This book has great value in that there are few if any books (or info on the web it seems) that take an integrated, holistic view of retirement financial planning to show how the whole process starts with lifestyle priorities that then drive a number of complementary financial components and actions. There are many books or websites from which one can obtain precise and comprehensive information and guidance on individual elements such as RRSPs/RRIFs, insurance or annuities but none that put it all together. The book covers all the acronyms and keywords at various degrees of depth: RRSP, locked-in RRSP, RRIF, LIF, LRIF, CPP, OAS, pensions, insurance, annuities, probate, wills. estates, trusts, power of attorney, capital gains, dividends, interest, bonds, equities.

I found very useful Diamond's discussion of the critical lifestyle priorities, namely providing sufficient income throughout retirement (i.e. making sure not to run out money), especially considering major health care requirements for critical illness and long term care, and whatever desire there is to pass along wealth to family or friends (i.e. not the taxman). It was also very helpful to read the explanations of insurance and annuities, something I have not yet spent much time learning the ins and outs of.

The book's stated objective to provide introductory, conceptual level treatment is also, for the DIY person, a major limitation. Diamond's constant refrain is: "to work out an actual detailed plan, go see a financial planner". Is it really beyond the capabilities of an interested, reasonably intelligent person who takes the trouble to buy and read such a book, to go ahead on his/her own?

The other important caveat is that the book needs a major quality improvement overhaul and significant updates. Diamond may be a good financial planner but he needs the services of a good editor to improve grammar, sentence construction, explanations, organization/story line, labeling and such. Many times I found myself saying to myself that something was incorrect, only to think about it and figure out that it was just the awkward explanation. The update is needed for important changes that have occurred since the 2003 publication date: new tax rates for dividends, tax brackets, foreign content rules for registered accounts, RRSP maturity (in the brand new federal government budget) and the introduction of variable payout annuities, which are not mentioned at all (and which annuity authority Moshe Milevsky termed a development which has "... the potential to revolutionize retirement financing in Canada." in his paper How to Completely Avoid Outliving Your Money (about which I wrote a post a few weeks ago).

A pet peeve of mine is the short shrift he gives to Exchange Traded Funds, exactly 11 lines of text, while the whole body of his discussion assumes the use of mutual funds for equity holdings.

Among the interesting but puzzling observations Diamond makes is that the first ten years of retirement are the best ones. Now it makes sense that declining health will limit activities as one gets older. But what if I decide to retire in my mid 50s? Does it mean I will be worse off after 65 compared to someone who retires at 65 and begins to enjoy his ten best years? And in financial terms, will I need less from 65 on than someone who starts his retirement at 65?

It would be very beneficial for the updated revise edition to include four or five annotated case studies of a complete financial plan. Certain themes and situations must arise often enough to be relevant to a large portion of the public. With all his experience, Diamond would surely be able to identify them.

In sum, this is a useful but by no means definitive book on the subject of personal financial management in retirement.

Free Money at Renasant Financial?

A friend noted that today March 20th the shares of Renasant Financial Partners Ltd (TSX: REN) were trading around the $2 mark and wondered if it would be possible to get the $3 per share special distribution the company will be making on March 30th per this press release. Not a bad deal if it were so. But the press release states that the $3 would go to shareholders of record on March 22nd. Therein lies the rub and the explanation why it isn't possible to buy a share for $2 to get the $3 cash. It is simply that the shares are trading "ex-dividend" as of March 20th, that is, any shares bought on March 20th will NOT receive the distribution, which is a return of capital and not a dividend. The reason the payment is not included is that shares in Canada, as in the US, have three business days to settle and to appear on the company's records. Two days - March 20 to March 22 - doesn't make it. The Investopedia has a good explanation of how this works.

As a result, from March 19th to the 20th, the price of REN dropped by almost $3 ($2.92 to be exact). The chart from Yahoo shows this in operation, though it is a bit puzzling why the trades early in the day were around the $4 mark. Maybe some investors got confused about the ex-dividend status, or did they just think the remaining business minus the $3 payment was still worth only a buck less?

It's another illustration of the old adage "if it seems too good to be true, it probably is."

Book: The Intelligent Investor by Benjamin Graham

Reviewing this book is akin to judging Warren Buffett's stock picking prowess. In fact, it is so very directly, since Buffett was a student of Graham and states that he uses Graham's methods. The quote from Buffett on the cover says it all: "By far the best book on investing ever written." The proof is certainly in the pudding, as one learns that Graham himself was a tremendously successful investor. An appendix by Buffett details the phenomenal investing performance of a number of Graham disciples. The updates to 2003 by finance journalist Jason Zweig (Graham died in 1976) illustrate the timelessness of the book's investment principles by providing numerous examples from the Internet dot com bubble and frauds such as Enron and Worldcom. As well, Zweig repeats and amplifies Graham's points for anyone who may have missed the subtleties.

Apparently, the secret to success in investing is "don't lose". The book outlines in 600+ pages of detailed, practical advice, backed up with mountains of supporting data, how to put the odds on your side, avoid losing and make either reasonable/modest (the defensive, passive investor) or excellent gains (the enterprising, active investor). A key lesson is that unless one is willing to devote the time and energy into doing the investigation required, one should stick to a broadly diversified portfolio of bonds and stocks, such as buying the index directly like a portfolio of the Dow Jones stocks, Exchange Traded Funds and passive low cost index tracking funds.

Want to know how to actually carry out the famous "buy low, sell high" strategy, aka Value investing? Graham shows how to calculate when a stock is low (what current ratio, earnings per share, debt coverage etc - no vague waffling here!) and when it is too high. The trick is finding such companies and prices. Only problem for us investors is that this requires lots of never-ending work, there's no escaping it. That's for the enterprising investor. For the rest of us, the emphatic advice is, be a defensive investor who doesn't pretend to know where markets or particular stocks are going. Instead, we are told to put together a portfolio with both equities and bonds (no more or less than 75% in each) that is well diversified and regularly rebalanced (every six months according to Zweig).

Despite being replete with tables of numbers, footnotes on virtually every page, copious references, citations of academic research, appendices, there is not an oppressive feeling of density to the text and boredom does not descend. The writing flows very easily, the explanations are unambiguous and the presentation follows naturally and logically. There are constant juicy bits to copy and remember. e.g. "... the investor's chief problem - and even his worst enemy - is likely to be himself." or "... the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions." or "... the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."

No doubt my copy will get many re-readings. Just wish I had bought it twenty years ago. Maybe this book should be made compulsory reading, with a test, before anyone is allowed to buy securities. ... on the other hand, because most people don't apply Graham's investment principles, as Warren Buffett says in the appendix, "There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd (referring to the more technical book written by Graham with David Dodd called Security Analysis) will continue to prosper."

Buy this book at
chapters.indigo.ca