21. Stocks, Bonds or Cash? How do you decide?

Transcript:

Evan Neufeld: Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host Evan Neufeld. Today we're back in my summer series here. We’ll have more frequent, but shorter episodes on the topics of investing smarter and reducing taxes.

Now with me in studio or more specifically in my office here, I'm very lucky to be joined by Steven Guenther, Certified Financial Planner and my colleague here at Enns and Baxter Wealth Management. Steven, thanks for coming. 

Steven Guenther: Thanks Evan. Looking forward to the summer series.

Evan Neufeld: Last week we talked about risk and this week we're going to be talking about something called asset allocation. Now, if there is jargon in any industry, ours is full of it. So what does asset allocation mean? 

Steven Guenther: Well, with investing, you have a number of different asset types. And so you have to make the decision of where you're going to allocate your capital, or where are you going to put your money within those asset types? Are you going to put them all in one asset type? Are you going to spread it in different parts to different types of assets and based on your objectives, try to pursue or weight higher, some asset classes over some others. 

Evan Neufeld: And some examples of those asset classes, the big ones that we often hear about stocks, bonds, or we might go back and say, equities, fixed income, if we're looking to add a little bit more jargon here cash is another one. What are some other ones that people might have that maybe they're not really even thinking about.

Steven Guenther: Well, real estate, house, they might own a rental property, or farm land. You could have exposure to commodities that have exposure to private equity, currencies, especially nowadays, we've heard a lot about cryptocurrency.  It's another asset class, even precious metals like gold and silver, copper. Those are all asset classes. 

Evan Neufeld: So I think we're going to keep to the main ones here, but if you're looking at someone's personal portfolio, if you will, or if someone's personal balance sheet, what about things with like four wheels, vehicles, RVs, things like that.

If someone has a really high allocation to depreciating assets like that, that could be problematic too, but we'll maybe stick with the appreciating assets or assets that we're hoping will increase in value over time.

When we talk about asset allocation, again, it's that mix between the things that you own, that you hope to achieve a certain goal over a period of time. So when we talk about assets and the potential for return, this pairs pretty well with the conversation we had last week on risk. So how much risk you're willing to take should be reflected in the asset allocation that you have? Would you agree with that? 

Steven Guenther: Absolutely and then the objective. Usually there's correlations like age, for example, is a good one. Usually the older you are, the less risk you're taking on because your goals are more short term in nature. You don't have as much time on your side. But that's not always true.  I mean, you can be a young person saving for a house. Doesn't mean you should have all of your money in private equity or equities in general, for example, which carry higher levels of risk. But the concept of asset allocation ties in with risk and the idea there is, we're trying to achieve something called diversification anytime we invest.

And so one of the ways we do that is by splitting up our capital into different asset classes, because depending on your asset class there's different levels of correlation between those asset classes. So correlation effectively means when the stock market goes up, for example, what are the other asset classes doing?  Are they also going up? That's what we would call positive correlation. 

Evan Neufeld: Let's say let's use a real example here. Say stocks in the U S go up, do Canadian stocks, go up at a similar rate. 

Steven Guenther: They're correlated, but not perfectly.

Evan Neufeld:That's right. So they're going to move independently a little bit, but they're going to move up and down relatively similarly. Think of last year during COVID, both the Canadian stock market and the U S market had that big correction, you could call it, some might call it a crash and then the subsequent gain steadily over time.

Again, the stock market takes the elevator down and the stairs back up. We could kind of see that in both Canada and the U S, but what about something like bonds at the same time? 

Steven Guenther: You look at different periods and there's different levels of correlation. But the important part is when you're trying to create diversification that you want to pair non-correlated assets that are still positively returning.  So for example, the conventional balanced portfolio is 60% equities and 40% bonds. That is because if you look history, not over all time periods, but historically bonds are potentially negatively correlated at times with equities.

Evan Neufeld: Negative correlation means if stocks go down bonds go up.

Steven Guenther: That's correct. So you've got this balancing effect. So if you have 40% of your portfolio in bonds and 60% in equities, the theory goes that when stocks are down, the bonds will hold up the portfolio.  When bonds are not doing as well or paying low yield, your equities are usually doing pretty well, interest rates are low. It's kind of a positive environment for equities. So that's the thesis there is that if you blend the two together, they're non-correlated, or even potentially negatively correlated, which will provide a smoother ride and allow you to not have as much of that downside. Both from an emotional standpoint, but from a portfolio standpoint that you won't experience as much downside.

Evan Neufeld: Right, and so even though you might be comfortable with the movements of the stock market day to day, over time you might realize, well I'd prefer to have a little bit more of a smoother ride here. So instead of having a really bumpy ride with all equities or all stocks. You could potentially include some other asset classes to help smooth out the ride.

That's kind of what you're getting at.

Steven Guenther: A good example we've seen historically and this happened again with the COVID crash of 2020, is the people always flock to safe assets in times of crisis. So a good example in a perpetual safe asset is gold. 

Evan Neufeld: Whether that's a real thing or just another type of speculation has another conversation maybe.

Steven Guenther:You see this movement towards perceived safe assets, like gold or like cash. I mean, that's probably the best one, cash. But you will find that gold is sometimes negatively correlated with the stock market. Because when times are good, the economy is ripping and everybody wants to get into stocks. When times are bad, there's crisis and people are selling their stocks and getting into things like gold. They feel like that has more intrinsic or perpetual, whatever word you want to use, value. That's the last thing, which is kind of ironic again, based on what it actually is, but yeah. 

Evan Neufeld: You mean that shiny rock is going to have value when the world ends!

Steven Guenther: I mean, cash is the ultimate safe asset because there's no return, there's no risk per se. It's the base level of value that we can use within our economy for transactions. But the challenge there is, of course it's subject to inflation. So you don't want to also hold a bunch of cash. I mean, this is the challenge with asset allocation is you have to have an appropriate mix for your objective, that involves diversification and appropriate level of risk for your objective. There's kind of several layers there, but the idea is your asset allocation has to match your goals and has to be diversified within those asset classes.

Evan Neufeld: So if somebody is trying to figure out how much they should have, like my goal is this. Now what, there are various tools that your financial advisor, your financial planner, or your self-directed broker or robo advisor even, they would have questionnaires that you could fill out that would ask you a variety of questions about how you feel about risk, your current financial situation and timeline. Then it'll kind of spit out an answer at the end that says, okay, this might be an appropriate mix for you based on that.

Steven Guenther: I think the conventional family will have maybe a home, two incomes, some kids and want to retire one day. They come to a financial advisor or they're doing it on their own and they want to know, okay, what kind of asset mixes is suitable for retirement, maybe 30 years from now?

Well, there's a number of things in that example, but we've got time on our side and time's good because it's the opposite of gambling. The more you play as in the longer time you have, the higher the likelihood you're going to win, you're going to have a gain.  Where in gambling it’s the opposite.  The more you play, the more chance the house is going to win naturally because the odds are known. You're going to get back tothe average, right. Which is a loss of course. So we have time on our side when we're investing for retirement. Then you move down the chain. Okay what's our objective?  Well, we don't need any income from this investor. We were just putting it aside, leaving it for 30 years. So then our main objective is growth. Have the money grow over time. So there's a large pot there when we're ready to use it. And then the third thing is your risk tolerance, which comprises both the psychological components and then also the capacity component.

But those three categories will start the conversation on what types of assets are suitable. So naturally the longer the time you have, the higher the risk tolerance that you have and the more growth based of an objective you have, the more aggressive you can be with your asset allocation. And you can do this on a line.  You can plot different asset classes based on the relative risk level. So you've got cash, let's say on the far left side and then, I mean, you can pick your poison on the far right. 

Evan Neufeld:Maybe it’sBitcoin on the far end

Steven Guenther: Let's put Bitcoin there, highly speculative asset, super volatile, but anything in between you can plot asset classes and naturally the more time you have, the more risk tolerance you have, the more suitable asset classes towards the right of the continuum would be within your given portfolio.

Evan Neufeld: That doesn't necessarily mean they should have a hundred percent in that asset class, but it's the likelihood that you could consider including it.

Steven Guenther: But naturally your allocation will be determined by those three categories.

And so depending on you may not play in the far right end. I know many of our clients, we're not touching a lot of that stuff in the far end of the spectrum, we’re instead staying to more of the mainstream. So stocks, bonds, real estate commodities, or the middle of the road type a more mainstream asset classes that most people are familiar with.

And that for the most part, usually allows people to reach their retirement goals, for example. So the weightings between those is where we would probably get more involved trying to help position a portfolio in accordance with somebody's goals.

Evan Neufeld: Right. And so then to keep things simple, like, I don't mean this plug has to make things more complicated, but like once people know what your approximate allocation should or might be. To find an appropriate investment that matches that is a lot easier than it once was actually. Most mutual fund companies, most ETF providers will have something called an asset allocation fund or ETF, depending on your different risk profile. So some might include, 20% bonds and 80% stocks, or it might be a 50/50 mix or, you know, anywhere along that line.

But if you're looking for something really easy, the products are out there. So you can talk to your financial planner, your advisor, you can do some Google searching and find some options that will be kind of like a one-stop shop for different asset allocation, depending on what your goals are.

Okay, Steven, I think that's it for the asset allocation episode. So to invest smarter, you should have a good idea of what your asset allocation should be, and then find an investment that matches your profile to make sure that you don't have unnecessary risk in your portfolio. 

Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes.

This podcast is intended to be educational in nature, and you should always consult your financial, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Qualified Associate Financial Planner and Registered Investment Fund advisor. Mutual funds are provided through Sterling Mutuals inc.