When I started investing with exchange-traded funds (ETFs) a couple of years ago, I was obsessed with building the perfect portfolio. I knew that asset allocation—the mix of stocks, bonds, real estate and other asset classes in a portfolio—is one of the most important decisions an investor will ever make, so I really wanted to get it right. I eventually cobbled together about a dozen ETFs, covering everything from emerging markets, to real-return bonds, to U.S. small-cap value stocks.
I admit I went overboard. Adding all of these asset classes to my modest RRSP has made it difficult to manage, and any higher returns I might expect were modest. “At some point, you’re slicing the pie so thin that you can’t even taste it anymore,” says Rick Ferri, author of All About Asset Allocation and founder of Portfolio Solutions in Troy, Mich. What’s more, Ferri says, using too many asset classes often means higher costs. “When you’re slicing the pie, some of the pie always ends up on the knife.”
So how many asset classes do you need to build a diversified Couch Potato portfolio? There’s no magic formula, but the answer is probably between three and 10. Here’s how to find the number that’s right for you.
Start at the top
Asset allocation is about deciding how much risk you want to take. The first step in building any portfolio, then, is balancing riskier stocks and safer bonds. “Once you determine your overall stock and bond mix, you’re 90% of the way there,” Ferri says. One rule of thumb says your bond allocation should equal your age: that is, a 40-year-old might put 40% of her portfolio in bonds and 60% in stocks.
Think this through carefully: no other decision will have a greater effect on your returns. Although people love to say “everything goes down in a crash,” that’s not true. During the meltdown of 2008-09, safe haven government bonds went up by about 5%. Which means that a portfolio of 20% stocks and 80% bonds lost only about 6%. Meanwhile, an investor who was 80% in equities lost about 40%. If you were in retirement at the time, that difference could have been life-changing.
The core four
Once you’ve decided on your overall stock and bond mix, consider how you’d like to divide these main investment types. The humble Global Couch Potato, with its four asset classes, may be all you need. This portfolio puts 40% of your money in the broad Canadian bond market. On the equity side, it allocates 20% to Canadian stocks, 20% to U.S. stocks, and 20% to international stocks.
It may look simple, but the result is a sophisticated portfolio. “These basic asset classes are all you need to capture most of the returns out there,” Ferri says. The portfolio includes more than 2,000 stocks and bonds in more than a dozen countries, all for a low fee of about 0.5% annually.
Some worthy additions
I use the Global Couch Potato in my kids’ education accounts, but as I’ve already confessed, I’ve sliced my RRSP more thinly. Ferri agrees that several asset classes are worth adding to a portfolio as it approaches $100,000 or so, though he stresses that investors who want to keep things simple shouldn’t feel compelled to.
What should you add? On the equity side, consider real estate investment trusts (REITs) emerging markets, small-cap stocks and value stocks, while real-return bonds are a good addition to the fixed-income side.
Let’s say you want to build a portfolio with 60% stocks and 40% bonds. You might put 20% into Canadian equities (10% in a broad-market fund, 5% in small-cap stocks, and 5% in REITs). Then you might put 20% in U.S. equities (10% in a broad-market fund, and 10% in a value fund). That leaves 20% for international equities (10% in developed and 10% in emerging markets). For the bond portion, you might go with 10% or 15% in real-return bonds, and the rest in a broad-based fund that includes both government and corporate bonds. ETFs are available to cover all of these bases.
Set it and forget it
If you’re like me, you’ll spend months wondering how you could have made your portfolio even better. Ferri stresses there is no perfect asset mix, so stop looking for it. “There is no right answer. We don’t know what the optimal allocation is, just as we don’t know which horse will win until the race is over.”
So whatever allocation you settle on, stick with it. About once a year, rebalance by trimming the asset classes that have done well and propping up the laggards. (If you’re investing with ETFs, don’t do this too often: the trading costs can outweigh the benefits.) Every five years or so, consider making your retirement portfolio more conservative, by bumping up the fixed income portion by 5% or so. Other than that, leave it alone.
“The best strategy is one that you can maintain, whatever it is,” Ferri says. “If you implement it, and you rebalance it, and you don’t tinker with it, then it’s going to get you where you need to go.”