Investors generally hold fixed income either to reduce overall portfolio volatility or to generate a reliable income stream. Some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio. Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.
More often than not stock talk seems to occur around the water cooler. The discussion seems to circulate around whether you should own Cameco or if your Shore Gold will once again reach its highs. However, the discussion really should begin with your decision around what portion of your portfolio should be stocks versus bonds. Choosing a basic stock-bond mix is an important first step in portfolio design. Although the decision may appear simple, it can have a profound impact on your wealth.
Portfolio theory explains the value of making a deliberate, strategic decision about the proportion of stocks versus bonds to hold in a portfolio. This theory proposes that all investors face two important decisions:
- deciding how much risk to take, and then
- forming a portfolio of “risky” assets (equities) and “less risky” assets (fixed income) to achieve this risk exposure.
The theorem proposes that all investors who are willing to take stock risk should begin with a diversified market portfolio. Each investor then can dial down total risk in the portfolio by adding fixed income to the mix. The greater the bond allocation relative to stocks, the less risky the portfolio and the lower the total expected return; the greater the stock allocation relative to bonds, the higher the portfolio’s expected return and risk.
Investors who want to take even more risk than the market can increase exposure through borrowing on margin and/or tilting the stock portfolio toward asset groups that offer higher expected returns for higher risk.
So, how does one confidently allocate between stocks and bonds? A common method is to evaluate model portfolios along the risk-return spectrum. A riskier portfolio holds 100% stocks, and the least volatile portfolio holds 100% bonds. Between these extremes lie standard stock-bond allocations. Then you compare the average annualized return and volatility (standard deviation) of each model portfolio for different periods. Volatility is one of several risk measures investors may want to consider. With this in mind, the analysis should feature average returns, as well as best- and worst-case returns for various periods.
This technique typically helps you think about the risk return tradeoff and visualize the range of potential outcomes based on the aggressiveness of your strategy.
After establishing the basic stock-bond mix, investors turn their attention to refining the stock allocation, which is where the best opportunities to refine the risk-return tradeoff are found. Investors who are comfortable with higher doses of equity risk can overweight or “tilt” their allocation toward riskier asset classes that have a history of offering average returns above the market. Research published by Fama and French found that small cap stocks have had higher average returns than large cap stocks, and value stocks have had higher average returns than growth stocks.
The final step in refining the stock component is to diversify globally. By holding an array of equity asset classes across domestic and international markets, investors can reduce the impact of underperformance in a single market or region of the world.
Research shows that two risk factors – maturity and credit quality – account for most of the average return differences in diversified bond portfolios. Long-term bonds and lower-quality corporate bonds typically offer higher average yields to compensate investors for taking more risk. But keep in mind that these premiums are considerably lower than the market, size, and value premiums documented in the equity world.
Investors generally hold fixed income to either reduce overall portfolio volatility, or generate a reliable income stream. These objectives typically lead to different investment decisions. The first approach, volatility reduction, is an application of the primary portfolio theorem. Rather than increasing risk to maximize yield, these investors want to hold fixed income securities that are lower risk.
With this in mind, some long-term investors may seek to earn higher expected returns by shifting risk to the equity side of their portfolio.
Whether investing for total long-term return or for income, a portfolio should be diversified across issues and global markets to avoid uncompensated risk from specific issuers and to capture differences in yield curves around the world.
The stock-bond decision drives a large part of your portfolio’s long-term performance. During portfolio design, evaluating different stock-bond combinations can help you visualize the risk-return tradeoff as you consider the range of potential outcomes over time. Once you determine a mix, it can guide more detailed choices of asset classes to hold in the portfolio. And as your appetite for risk shifts over time, you can revisit the mix to estimate how shifting your portfolio mix may impact your wealth accumulation goals in the future.
This article by Daryn Form was published in the January 2012 edition of Sask Business Magazine.
Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd. Rates are not guaranteed and are subject to change at any time without notice.