Taking the mystery out of asset allocation - Situational Financial Planning, Legal & ID Shield, Halifax, Nova Scotia, Canada

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Taking the mystery out of asset allocation


Taking the Mystery Out of Asset Allocation

1.  Broad assets classes and their percentages
2.  Specific securities within those classes
3.  Correlation
4.  Strategic asset allocation, Modern Portfolio Theory and Efficient Frontier
Asset allocation is the process of determining the proportions of different assets to be included in an investment portfolio. It’s a multi step process. The process begins with a decision on the broad asset classes to include in a fund and the exact percentage to allocate to each class. Depending on the type this may be more complicated than it seems. An equity fund, for example, will most likely contain securities only from the equity asset class. A balanced fund however, could contain both fixed income and equities.
Once the broad asset classes and their percentages have been identified, the next step is to select specific securities within those classes. This is where it gets complicated. The fund manager now must do hours of research to decide which securities to include in their fund. Needless to say, fund managers rely quite heavily on teams of analysts to help them make buying and selling decisions for the fund. If you have invested money today in any form of mutual fund you will likely have gone through an asset allocation process. Done only once and left alone an asset allocation process becomes less and less of value. Since the asset allocation process leads you to certain investments there will be growth or losses over time in those investments. You have to ensure that a re-balancing or review takes place on a regular basis within your portfolio. Only by coming back within you risk profile will you maintain the integrity of your plan.
The next step is to decide how this all comes together to meet your needs and match your Risk tolerance. This is where correlation and the Efficient Frontier come into play. Strategic asset allocation is one of the principles of Noble Prize winning Modern Portfolio Theory. Modern Portfolio Theory in turn, is how the concept of the Efficient Frontier was developed.

Correlation shows the relationship that one investment has with another. That relationship can be quantified by a correlation value. The correlation values are between +1 and -1. The closer the correlation of assets is to +1, the more closely returns move together (i.e. the fund goes up, the other fund goes up). On the other hand, the closer the correlation of two assets is to -1, the more divergent the returns are (i.e. one fund goes up, the other fund goes down). You should use a process with software that takes into consideration the correlation of all the funds involved. If you didn’t take correlation into account, your portfolio wouldn’t be properly diversified and you will be exposed to more risk.

Strategic asset allocation software are scientifically developed to identify combinations of investments that offer the best return at the least risk. For example to determine these combinations, the returns of all types of investments were examined for the past 40 years. Then sophisticated investment optimization software was used to calculate the most effective investment combinations for each level of risk. These combinations form the Efficient Frontier, which is the basis for each investment profile. Each dot in this graph represents a specific fund. The line represents the Efficient Frontier – the specific combination of funds that produce optimized returns at each level of risk.

Here is a sample using these combinations to produce five investment profiles.

75% Fixed Income

20.5 % Canadian Equity

4.5% Global Equity


60% Fixed Income

25% Canadian Equities

15% Global Equity


40% Fixed Income

40.3% Canadian Equities

19.7% Global Equity


20% Fixed Income

57% Canadian Equities

23% Global Equity


73% Canadian Equities

27% Global Equity

You’ll notice that each profile, even the most conservative one, includes some equity component.

  • This is because without equities there is little or no growth in a portfolio.

Therefore, even the most conservative investor needs some equities in their portfolio to create growth in the investments.

"Too many cooks can spoil the broth”
If you have funds invested through several different sources and you have not looked at your overall diversification including correlation then your portfolio is likely not properly diversified.

The next steps

1. Solidify your investment objectives and your investment philosophy.
Achieve long-term growth with the lowest possible level of risk along the way? Conserve for your legacy? Increasing income? Conserve capital?

2.  What is your current situation?
Complete a questionnaire to determine your risk profile

A quantitative analysis of your existing portfolio will determine if it matches your risk profile provide a diversification analysis

3.  Recommendations
Specific to each situation

4.  Action Plan

Rebalance and transfer assets as needed (may be taxes and or fees)
Review and rebalance as needed. (As one portion of the portfolio grows faster than another)

A description of the key features of the segregated fund policy issued by the insurance company is contained in the information folder. Any amount that is allocated to a segregated fund is invested at the risk of the policyowner and may increase or decrease in value.

Paul is a Certified Financial Planner (CFP) licensed by the Financial Planners Standards Council; Financial and Estate Plans are provided under that license.

The information contained in this website is intended to provide general guidelines only. The application and impact of the law can vary widely from case to case based on the specific or unique facts involved. Accordingly, the information in this article is not intended to serve as legal, accounting or tax advice. Users are encouraged to consult with their professional advisers for advice concerning specific matters before making a decision.

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J. Paul Wilson, CFP®, ChFC®
Certified Financial Planner
27 Blue Thistle Road Halifax, Nova Scotia, B3S 1M3
Office (902) 405-8665 Email  paul@jpw.ca
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