It is common knowledge that healthy eating and regular exercise is the path to a healthy body, inside and out. But it is a lack of discipline — not a lack of knowledge — that explains why a healthy lifestyle remains elusive for so many. So, a reminder of the keys to success is always helpful.
Successful investing is no different. To that end, here are reminders to help make you a better investor and, in turn, a better advisor.
> Document Goals. In many aspects of life, simply writing down your goals increases your chances of success. In investing, this takes the form of an investment policy statement.
An IPS need not be lengthy or complex. But it should lay out a summary and analysis of the following seven objectives and constraints: return target, risk tolerance, time horizon, cash needs, tax considerations, legal considerations and special circumstances. Designing an IPS when emotions aren’t running high is ideal because it acts as a reference when fear or greed kick in.
> Diversify, Don’t Di-Worsify. Even before the credit crisis and bear market set in, investors in mutual funds reporting to the Investment Funds Institute of Canada realized a 15-year compound annualized return that roughly equalled that available from guaranteed investment certificates over the same period. A key factor in this disappointing performance is performance dilution resulting from di-worsification.
When constructing portfolios for clients, it is critical to diversify prudently to limit risk without diversifying too thinly. Such di-worsification simply leads to an index-like portfolio with active management fees. The result is performance dilution.
Accordingly, I have long challenged advisors to view their books of business as one portfolio. I’m not suggesting that all clients should have the same portfolio. But to better your clients’ chances of outperforming the index, the funds or managers chosen for each asset class must be consistent across all client portfolios.
Using seven or eight mid- or large-cap Canadian stock funds across your book is problematic because it creates an inconsistent client experience. It also means that, overall, your clients’ Canadian equities exposure runs a higher chance of underperforming in both absolute and risk-adjusted terms.
Choosing one or two funds for this exposure means more risk of underperforming but also a greater chance of success. You’ll need greater confidence in your investment choices — which, in turn, requires more in-depth due diligence and oversight.
> Rebalance Periodically. A complete IPS should also specify rebalancing parameters — but these are only valuable if followed. You’ll need some faith, however, because rebalancing methods that make the most intuitive sense (and that have produced great results over time) have not worked well in the past three years.
Let’s use a 50/50 balanced portfolio from January 1980 through November 2009 to illustrate. Lack of rebalancing resulted in returns of 70 basis points annually in excess of that seen by full monthly rebalancing, with less risk. However, over the past five years, monthly rebalancing has provided almost 4% more than no rebalancing. It is best to think about rebalancing as a risk-control discipline, not a return-enhancer, when determining the method that best suits clients.
> Treat Portfolios Like Bars Of Soap. The makeup of a portfolio based on the design of an IPS should only be changed if one (or more) of the seven objectives and constraints changes. Otherwise, fad-chasing and other emotional decisions are likely to result. And those never end well. As the saying goes: treat your portfolio like a bar of soap — the more you touch it, the smaller it gets. IE
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Asset Management Inc., which designs portfolio solutions for advisors, affluent families and institutions.