Asset allocation is the division of a portfolio among asset classes. Research on pension funds (Brinson, Hood and Beebower, 1986) found that the policy mix explained the great majority of the variation in a fund's returns over time, far more than security selection or market timing.
A written document that sets:
The long-run target mix, built from long-run expectations of return, risk and correlation for each asset class. Common starting points:
Short-term deviations from the strategic mix to exploit perceived mispricing. It adds value only if forecasts are right more often than costs and errors take away.
Markets push weights away from target, which changes the portfolio's risk. Rebalancing sells what has risen and buys what has fallen.
Example: $100,000 at 60/40. Stocks rise 20% and bonds are flat: stocks $72,000, bonds $40,000, total $112,000, a 64.3/35.7 mix. To restore 60/40, stocks should be $67,200, so sell $4,800 of stocks and buy bonds.
Calendar rebalancing happens on a fixed date each year. Threshold rebalancing happens when a weight drifts beyond a band, such as 5 percentage points. Use new contributions and dividends first to limit trading costs and taxes.
Canada is only about 3% of world stock market value and is concentrated in financials and resources. Investors everywhere hold far more domestic stocks than global weights suggest. Some home bias is defensible (currency matching, tax credits on domestic dividends, lower costs), but a heavy home tilt gives up diversification.
Foreign assets carry currency risk. Hedging removes it at a cost linked to the interest rate difference between the two countries. Many investors hedge foreign bonds, where currency swings would dominate, and leave foreign equities unhedged.
Which account holds which asset affects after-tax return. Master Your Money covers the TFSA, RRSP and FHSA rules, including the treatment of US dividend withholding tax.
Assumptions: stocks 7% expected return and 16% volatility; bonds 4% and 6%; correlation 0.1.
Changing the correlation assumption to 0.5, closer to 2022, raises volatility to about 11.0%. Stress the correlation, not just the returns.
Target-date funds reduce equity exposure as the target date approaches, typically from around 90% equities decades away to 30% to 50% at retirement, and continue de-risking for some years after. The logic: a young investor's future earnings are like a large bond holding, so the financial portfolio can carry more equity risk; near retirement, a large loss cannot be recovered by future work.
Pension plans and insurers care about assets relative to liabilities. A pension that owes payments far in the future holds long-duration bonds so that when interest rates fall and the liabilities' value rises, the bonds rise too. For them, 'risk-free' means matched to the liabilities, not cash. Individuals can apply the same idea by matching near-term spending needs with bonds or GICs of matching maturity.
With a 60% equity target and 5-point bands, rebalance when equities reach 55% or 65%. Rebalancing in late 2008 and early 2009 meant buying stocks after a 50% fall, which felt terrible and was rewarded handsomely. A written rule makes it possible to act when it is hardest.
An investor holds $100,000 of bonds yielding 4% and $100,000 of Canadian stocks. In a taxable account, the bond interest is fully taxable each year; Canadian dividends receive the dividend tax credit and capital gains are taxed only when realized and at a lower inclusion. Placing the bonds in the RRSP and the Canadian stocks in the taxable account usually leaves more after tax than the reverse. Master Your Money covers the details and the US-dividend withholding rules.
Write a one-page IPS for yourself with all seven elements, a strategic mix with target weights and bands, a benchmark for each asset class and a rebalancing rule.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.