This article describes a process for portfolio design and construction. A portfolio is a grouping of financial assets such as equities (including stocks), fixed income (including bonds) and cash. It is a generally accepted principle that a portfolio is designed according to the investor's risk tolerance, time frame and investment objectives.

Portfolios are held directly by investors and/or managed by financial professionals. Mutual funds (including index funds) and exchange-traded funds (ETFs) are typical portfolio building blocks; more advanced investors might choose to select individual securities within the main asset classes.

Once a portfolio has been constructed, there is still a need for ongoing monitoring and maintenance to ensure that the portfolio objectives are being met and to deal with any life events or changes in circumstances.

The outcome of this process should be the basis for your investment policy statement.

 

 

Overview of the process

The first step is to make sure you are ready to invest by doing an self-assessment.

The second step is creating a financial plan, which identifies what are the specific objectives of the portfolio, such as retirement or another project, along with a time horizon. If your time horizon is really short and money is being invested that will need to be used within a few years, STOP! Putting your house down payment in the stock market is folly, as return of capital is more important than return on capital.

The third step is to establish an asset allocation, and a savings target, that together are likely to lead to the financial goal being reached within the specified time horizon. The most important decision in the asset allocation exercise is the division between equities (stocks) and fixed income (bonds, Guaranteed Investment Certificates (GICs), High-interest savings accounts (HISAs) and cash), as this is the major determinant of expected portfolio return and expected volatility.

A secondary decision of asset allocation is how much foreign (as opposed to domestic) content to include. For fixed income, keeping it all domestic seems appropriate for many Canadian investors. For stocks, some global diversification is generally advisable, due to several factors including the sector concentration in the Canadian stock market, and the expected reduction in portfolio volatility.^[1]

When the appropriate allocation has been established, the fourth step is to implement the portfolio. Examples of both simple (one to five asset classes) and complex (generally more than five asset classes) portfolios are examined here, notably using index mutual funds or ETFs. Security selection within the asset classes is also a possible strategy for more advanced investors.

The fifth step is the ongoing monitoring and maintenance of the portfolio, which consists of rebalancing it to the target allocations, and measuring its performance against an appropriate benchmark.

Assess yourself

Before you create an investment portfolio, create a list of your financial assets and liabilities, or net worth. In general, investing in stocks or fixed income (bonds are a subset of fixed income) should come after other financial needs are met: debts such as credit cards, student loans or consumer debts are paid off; an emergency fund is established; sufficient insurance is in place. Some investors have both investment portfolios and house mortgages simultaneously; to some extent, this is a matter of personal taste and risk tolerance as well as a financial decision.

Saving a portion of your income is an obvious prerequisite for investing and building assets. If you are spending more than you earn, it is generally recommended to learn to live below your means. This may require budgeting.

Disclaimer: The mention of a mutual fund, exchange-traded fund, or other security in this wiki should not be taken as a recommendation to purchase or sell. Investors must conduct their own due diligence before investing. Similarly, description of tax and legal issues should not be construed as professional advice. Investors are strongly urged to consult an accountant or lawyer for specific recommendations to fit their personal circumstances. — The Management

Create a plan

A financial plan makes recommendations in a number of areas. Financial planning is not about amassing a pile of money. The initial and most important step is identifying objectives (in a family, agreeing on shared objectives), e.g. buying a house, retiring early, and/or ensuring that children get an excellent education. Determining what the objectives are is primary. Since what usually requires money in the modern world, financial planning then proceeds methodically to lay out how.

Set your level of risk (asset allocation)

Asset allocation is one of the most important decisions that investors can make. In other words, the importance of an investor's selection of individual securities is insignificant compared to the waythe investor allocates their assets to stocks, bonds, and cash equivalents.

The most important decision facing the investor is the division of his (or her) portfolio between high-risk and low-risk components. Traditionally, this is often referred to as the "Equity:Fixed income" (stocks / bonds) allocation, although the "fixed income" component using such terminology colloquially includes cash (which is formally a separate asset class).

Equity vs fixed income

An age and risk appropriate adequately diversified asset mix (asset allocation) will help protect assets during severe market downturns. What is age appropriate? A rule of thumb is "your age in bonds". So a 40 year old investor would have 40% fixed income (60% equities), and the proportion of fixed income would increase with time. When one is 20, there's a entire working life to recover from a downturn but when one is near or in retirement, recovery is not likely possible.

To illustrate the effect of the asset allocation on returns during a severe bear market, consider the effect of different ratios of equity to fixed income of a year in which equities lost 50%^{[nb 1]} and fixed income (bonds plus cash) gained 5%. The performance will be as follows:

One-Year Returns when equities lost 50% and fixed income gained 5%

Equities allocation	Fixed income allocation[nb 2]	Weighted Return
100%	0%	-50%
75%	25%	-36.3%
50%	50%	-22.5%
25%	75%	-8.8%
0%	100%	5%

Notes

1. Jump up↑ The S&P/TSX Composite Index, which does not include dividends, had a 52-week low of 7479.96 versus a 52-week high of 15154.77 for the year ending Mar. 10, 2009 - a difference of -50.6%.^[2]
2. Jump up↑ Including cash.

The equity to fixed income allocations of 75:25, 50:50, and 25:75 correspond roughly in asset allocation to the three FPX Indexes. Note that the 75% fixed income allocation sharply reduced the effect of the severe drop in equities. These concepts are further developed in Risk and return.

From 1900 to 2011, Canadian equities provided an annualized return of about 9%; long-term conventional bonds just over 5%; and treasury bills a bit under 5% (see Canadian asset class returns). The specific numbers are not particularly important; the key message here is that over long enough periods, stocks beat bonds, and bonds beat bills. How long is "long enough"? The 20th century contains three decades during which stocks were not the highest performer (see Canadian asset class returns), so the answer is probably "several decades". The same conclusion (stocks outperform over the long term) is reached when the US data is examined, and this is expected to continue in the future. However, with this extra return comes significant extra risk.

In a low interest rate environment, holding fixed income in a portfolio is often questioned because the return is so poor. A diversified portfolio is meant to reduce risk, not maximize returns. Once again, it takes a severe market downturn for one to realize that I guess I should have had some fixed income in my portfolio.

Domestic vs foreign asset classes

Once the fixed income:equity split has been decided, a second important – but difficult to answer – question is how much to allocate to foreign (or “global”), as opposed to domestic, asset classes. For fixed income, most Canadian investors will opt to keep it all domestic. For equities however, there are convincing arguments for global diversification.

Simple portfolios

The simplest portfolios use Guaranteed Investment Certificates (GICs) or single mutual funds. Other simple portfolios are based on using index funds or the corresponding ETFs to build a low-cost structure with a small number of funds (generally five or less) that are easy to rebalance.

The GIC or bond ladder

One of the simplest portfolios can be obtained by dividing the portfolio sum into several equal parts and investing each part in a GIC which matures in each of the subsequent years. A five-year ladder would have five GICs maturing one, two, three, four, and five years hence. Since certificates maturing more than five years in the future are not covered by the Canada Deposit Insurance Corporation (CDIC),^[3] a federally-guaranteed GIC ladder is restricted to a maximum of five years. A similar bond ladder, using Government of Canada bonds, can be extended up to 30 years.

Although a fixed income ladder may seem like all that's needed for the most conservative investors, portfolio theory suggests that including a small amount of equities (say 10-20%) in a portfolio may actually increase its return and lower its volatility.^[4] And for less conservative investors saving for retirement, a fixed-income ladder alone will probably not have the required expected return: a balanced portfolio combining stocks and fixed income will work better.

One-fund portfolios

The next step in complexity is a diversified (balanced) portfolio, which contains both fixed income and equities. This can be obtained with the one-fund solutions described here, or by building a diversified portfolio using your own combination of equity and fixed-income funds (or individual securities) as described in the subsequent sections of this article.

The first (and broader categorized) type of a one-fund portfolio is called a prebuilt portfolio. For example, target date funds are prebuilt portfolios with allocations that automatically change over time. Target-date funds (also known as "retirement-date" or "life-cycle" funds) have been described as the ultimate "set and forget" investment vehicle but they also have been criticized for high fees: "the management and trading expense ratios for these products hover around 2.3 per cent".^[5] They also have potential suitability issues.^[6]

Next, balanced funds are diversified portfolios which typically utilize fixed asset allocations, combining fixed income and equities into a single mutual fund. Balanced funds can be appropriate for new investors, as they are one of the simplest ways to obtain a diversified portfolio. There's no need to learn how to trade, or to perform rebalancing. However, simplicity comes at a price, since the average balanced fund in Canada has a management expense ratio (MER) of 2.15%.^[7] High MERs will seriously affect future returns (reduce the amount of money you have for retirement), as can be shown on the Mutual fund fee calculator | Investor Education Fund.

One-fund solutions also have a behavioural benefit. Investors who have difficulty watching the ups and downs of the market will be less tempted to trade, as movement of the fund's underlying components will be hidden from view. Frequent trading, especially when one attempts "market timing," is very likely to result in lower returns (relative to staying invested at all times).^[8]

While cost is certainly important, a one-fund portfolio is preferred for investors who don't want to manage the complexities of multiple funds, or are unable to handle the swings of the market. It is much better to start investing early with a higher-cost diversified fund than to delay or not invest at all.

In February 2018, Vanguard Canada announced the introduction of three new asset allocation ETFs^[9] that began trading on the TSX on February 1, 2018. These are new ETFs without an established track record, although Vanguard Canada itself has established a solid track-record of ETFs in Canada. Caution is generally recommending on using new products until such time as they do establish a track record and trading volumes and patterns are known.

Three fund, four fund and five fund portfolios

A low-cost way to achieve diversification between fixed income and equities is a three-fund portfolio that divides funds between (1) a Canadian bond index, (2) a Canadian equity fund and (3) a global equity fund^[10]. The three-fund portfolio is recommended for its simplicity and diversification.

The three-fund portfolio can be constructed by first selecting an appropriate asset allocation between stocks and bonds, and then dividing the stock allocation between domestic and global. Specific Index funds or ETFs are then chosen to implement the asset allocation. Such a portfolio has several advantages:

• very simple to understand and implement
• simple to manage, including rebalancing and paperwork
• diversified between stocks and bonds according to the investor's risk tolerance
• the stock portion has global diversification, promissing a lowered portfolio volatility^[11]
• very low costs
• enables caregivers and heirs to easily take-over the portfolio when necessary ^[12]
• no market timing or security selection involved
• allows you to spend more time with family and friends, and less time managing your finances

A four fund portfolio further decomposes the global stocks into two funds: US stocks and international stocks. The developed markets portion of "international stocks" is also known as Europe-Australasia-Far East (EAFE).^{[note 1]} The "Global Couch Potato" portfolio from Moneysense and Canadian Couch Potato is a well known example of a four fund portfolio designed for Canadian investors.

A five-fund portfolio separates international equities into EAFE equities and emerging market equities.

Different asset classes (see below) could instead be added to the initial three (Canadian bonds, Canadian equities and global equity) to compose four- or five-funds portfolios.

Complex portfolios

More sophisticated investors may wish to move beyond simple three, four or five-component portfolios and either include additional components; slice and dice existing components; or purchase individual stocks and bonds. The resulting portfolios may contain numerous asset classes and subclasses, and can be very individual in nature. This allows tailoring to meet the goals of an individual investor, but at the cost of additional complexity and, if security selection is performed, more frequent monitoring. Another potential issue with complex portfolios is the "urge to tinker": it can be tempting to change one's asset allocation too frequently, etc.

Example: 60 year-old retiree

Here is an example of a complex portfolio for a 60-year-old retiree. The Real Estate Investment Trusts (REITs), preferred shares and high yield bonds boost income, while the Real Return Bonds (RRBs) and gold provide inflation protection. This type of portfolio may require more frequent monitoring if security selection is employed.

Example of Complex Portfolio

Asset Type	Allocation
Canadian Stocks	15%
Canadian REITs	5%
US Equities	5%
International Equities	10%
Preferred Shares	5%
Gold	5%
High Yield Bonds	5%
Real Return Bonds	20%
GIC Ladder	20%
Cash	10%
Total	100%

Building a portfolio

The following example is modified from "Shakespeare's primer"^[13], with permission of the original author.

Example: Mid-thirties and starting to invest

Ed is in his mid-thirties and wishes to start DIY investing. He has an RRSP worth $10K and no non-registered investments. He wishes to add to the RRSP using monthly contributions. The RRSP is currently in a HISA, and there are no costs or delays associated with moving it.

With a modest investment amount and the desire to add monthly contributions, low-cost index funds are a better alternative than ETFs. Ed reviews "How to choose index mutual funds" and decides to use the TD e-funds for his portfolio. [The TD e-funds are used for illustration purposes only.] He establishes a TD mutual funds account, or an account at TD Direct Investing (formerly TD Waterhouse) and transfers his existing RRSP. He wishes to replicate the four-component portfolio listed above, using the FPX Balanced index for his target allocation and adding the cash component to the bond index. He purchases the following funds:

Ed's Portfolio^a

Fund	Amount
Canadian Bond: TD Canadian Bond Index - e	50% ($5000)
Canadian Equity: TD Canadian Index - e	25% ($2500)
US Equity: TD US Index - e	10% ($1000)
EAFE Equity: TD International Index - e	15% ($1500)

a. Index funds from other vendors could also be used.

Although Ed is very nervous about investing in equities because of the volatility, he recognizes that his time horizon is very long and he decides to contribute monthly to all four funds, automatically (using a systematic investment plan), in the proportions of his target allocation. This should keep the portfolio close to the target for a while, but eventually it will need to be rebalanced. Ed decides to use 5% absolute/25% relative for his rebalancing thresholds; if one of the holdings varies from the nominal level by 5% absolute (e.g. from 50% to 45% or 55% for the bond index) or by 25% relative (e.g. 7.5% to 12.5% for the US Index), he will rebalance by redirecting the monthly contributions appropriately until the holdings are back to their nominal percentages.

More complex examples would include factors like consideration of the tax or deferred-charge implications of selling current high-MER mutual funds, and could require the services of a Financial Planner.

Portfolio maintenance

Rebalancing

Rebalancing is part of portfolio maintenance, and should be done periodically or as circumstances require.

Measuring performance

You should review the performance of your portfolio annually, to ensure that it is meeting your objectives and is consistent with your plan. Further Reading provides a couple of very useful references on the subject.

One year, 3 years, 5 years and 10 years portfolio returns can be compared to suitable benchmarks, such as the FPX indexes, or home-made ones closer to an investor's actual asset allocation.

To calculate one year portfolio returns combining several accounts, Excel aficionados can use the XIRR function as described by gummy, in two different tutorials: XIRR^{[note 2]} and XIRR and its uses.^{[note 2]} A more up-to-date (and maintained) tool for calculating personal returns has been developed by FWF member longinvest. A key point is to take withdrawals and additions into account when calculating returns. To calculate annualized multi-year returns, the Excel function GEOMEAN can be used (see this).

See also

• Asset allocation
• Management expense ratio
• Simple index portfolios

Notes

1. Jump up↑ From a Canadian perspective, a global fund includes everywhere except Canada; an international fund includes everything except Canada and the US.
2. ↑ ^{Jump up to:2.0 2.1} August 2010 update from Gummy: I am now permanently retired from gummy-stuff and have passed care and feeding of the archive to the Financial Webring folks. They have promised to keep it unchanged and freely available to all. Bottom line, gummy's spreadsheet's are now unmaintained and provided on an as-is basis

References

Further reading

• William Bernstein. The Four Pillars of Investing: Lessons for Building a Winning Portfolio'. McGraw-Hill, 2002. ISBN 978-0-07-174705-9
• William Bernstein. The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk. McGraw-Hill, 2001. ISBN 0071362363
• Charles D. Ellis. Winning the Loser's Game: Timeless Strategies for Successful Investing. McGraw-Hill, 1998. ISBN 0070220107
• George E. Hartman. Risk is Still a Four-Letter Word. Stoddart Publishing, 2001. ISBN 0773761101
• Tom Bradley, Steadyhand Investment Funds. How Is My Portfolio Doing ... And What Should I Do About it? A Framework for Assessing Investment Performance, January 2011
• Tom Bradley, Steadyhand Investment Funds. How Is Your Portfolio Doing? A Framework for Assessing Investment Performance, January 2012

Other useful titles can be found in the Recommended reading section.