More details about Asset Allocation & Investor Profile correlation
“Your rates of return depends less on what kind of investments you own than on what kind of investor you are.” -Benjamin Graham
“You can be young without money but you can’t be old without it.”-Tennessee Williams
“I made my money the old-fashioned way. I was very nice to a wealthy relative right before he died”-Malcolm Forbes
“The will to succeed is important, but what’s more important is the will to prepare.”-Bobby Knight
“A very rich person, at death, should leave his kids enough to do anything, but not enough to do nothing.”-Warren Buffett
“Our favorite holding period is forever.”-Warren Buffett
“The worse investment risk is the investor himself.”-Benjamin Graham
“Risk comes from not knowing what you're doing.”-Warren Buffett
What is your Investor Profile?
Understanding yourself as an investor is one of the key factors in considering an appropriate portfolio asset allocation. Investor profiles range from extremely conservative to very aggressive which generally has a direct correlation to your selection and consideration of investment profiles.
You must ensure that you’re honest with yourself and that your self-assessment is accurate. Please mull over the different aspects of your personal financial situation and goals suggested below:
1- Your Life Stage
Starting up (irresponsible party animal)
You’re just finishing your formal education and beginning your first “real” job. You’re starting to develop sound financial habits for a lifetime. You’re establishing credit and maintain a good payment record. You’re trying to spend less than you earn. You’re setting up your first savings account. You’re starting to learn about investing and establishing an automatic savings program to reach your financial goals. You’re trying to take full advantage of the savings benefits available to you through your employer. You’re investment knowledge is limited and your youth and your risk tolerance makes you an active and aggressive investor.
Wealth accumulation (responsible professional)
You’re now working in your career. You’re saving what you’re not spending and investing what you’re saving. You’re thinking of buying a new car or a house. You’re planning to get married and have kids. You’re thinking about savings for a down payment, retirement, required investment growth and a kid’s education fund. You’re also thinking about security and growth of capital. You’re making sure you have adequate insurance coverage (life, home, auto, health, disability and liability) to protect your family. All these responsibilities and obligations make you an active but moderate investor.
Wealth Preservation & Consolidation (work freedom in the horizon)
You’re getting older and time to retirement is shrinking. You’re looking for a low risk portfolio to ensure the preservation of what you've accumulated. You’re thinking your equity exposure should gradually reduce in favor of relatively safe investments. You’re also thinking about tax planning and optimization. You’re now modelling retirement income & asset protection scenarios. All your wisdom and experience makes you a conservative investor.
Wealth Expenditure (too old to work)
You’re now upon retirement, hopefully your house is paid off and the kids are out of the house. You’re now worried about a steady income generation. You’re thinking about cash flow and asset management. You’re also thinking about tax minimization and to maximize social security streams. All this free time and limited resources makes you a very cautious and conservative investor.
Wealth Gifting (everyone is after your money)
Your life expectancy is shortening and you find yourself with more money than you need and you start thinking to give that money away or leave behind a legacy. Estate planning is something that is in your mind.
2- Your Investment Time Horizon
When do you expect to make use of this investment?
A general rule of thumb is the longer you have before you need to sell the investments that you are holding for a specific purpose, the more risk you may be willing to tolerate. Technically speaking a longer investment time frame allows for a more aggressive approach to investing.
If you have a shorter time horizon, you may want to consider less risky investment alternatives. If you need the money in just a couple of years for instance, you may want to invest it in cash and equivalent type investments that protects your principal.
3- Your Investment Objectives
Why are you investing your money? What is your main objective? A clear understanding of how much or how big your financial needs are, sets the stage for the investment planning.
- Are you saving for an emergency fund for unexpected financial situations?
- Are you planning for a dream vacation in the next few years?
- Are you dreaming about a new car?
- Are you saving for a house down payment?
- Are you thinking of a major house renovation project?
- Are you preparing for the kids college or university tuitions and related expenses?
- Are you forecasting your lifestyle when you retire?
In each case you will require a different approach to investing.
4- Your Risk Tolerance
What is your comfort level when losing money? Before you set out to make any investment decision, it is critical for you to have a feel for your risk personality.
Risk tolerance is the measurement of your willingness, as an investor, to suffer a decline in the value of your investments while waiting and hoping for them to increase in value.
Some people are risk tolerant, meaning they are more comfortable taking on higher amounts of risk when it comes to their investments. Others are risk averse, meaning they have a lower tolerance for taking on risky investments.
Each type of investment has an inherent degree of risk associated with it and a corresponding potential for returns. In general, the potential for investment reward tends to increase with the level of risk assumed. There is no point in investing in something if your decision will make you uncomfortable or lose sleep at night.
Unfortunately most people don’t know their risk tolerance and many investors have trouble determining the level of risk they can comfortably bear when considering investment options. It's easy to overestimate your ability to ride out the markets ups and downs, especially when the markets are booming. Many investors find they have overestimated the amount of risk – or volatility – they can cope with. So when the market does go south, many investors “panic sell”.
Playing too safe carries its own risk
It’s important to remember that your attitudes and willingness to accept risk can change over time depending on your life stage and any other aspect covered in this section. Also, while you are assessing your tolerance for risk, remember that playing too safe carries its own risk. If you leave all your money in a savings account that earns 3% and inflation is running at 4%, your money will lose 1% purchasing power.
5-Your Financial Situation
How much income do you have? What is your net worth? Do you live paycheque-to-paycheque? Do you easily meet your day-to-day financial obligations? Do you feel that your personal financial situation (net worth, regular income and ability to pay your bills) is secure? These are the questions you should ask yourself to determine your financial health and security.
6-Your Investment Knowledge
Your investment choices can be influenced by your understanding of how investments work. When it comes to investing in stocks, bonds and mutual funds, how would you describe your level of investment knowledge?
7-Your Investing Style
If you like driving around to find a garage/yard sale just to find a deal on something you need, you might have the profile of a value investor.
If you like to wait for Boxing Day to buy gifts on sale, you might have the profile of a value investor.
Value investors look to buy stocks that should be worth more than they are trading, maybe because they are out of favor.
If you like the excitement of an auction just to buy stuff with the hope of selling it for more, you might have the profile of a growth investor.
If you like the rush of Boxing Day to buy something that you don’t need just because is on the flyer, you might have the profile of a growth investor.
In contrast to value investors, growth investors often have a good deal of optimism factored into their price and may not be as concerned about a stock having a high price-to-earnings (P/E) ratio. As the name suggests, growth investors look for rapidly growing companies that exhibit, among other things, increasing sales and increasing profits.
8- Tax implications and other considerations
Taxes should always be a factor to take under consideration, but here is a little different perspective.
Would you rather pay $3,000 in taxes or $30,000? Common sense regarding taxes would dictate that less is better, but that would imply you only made $10,000 (at 30% marginal tax rate). If you paid $30,000 in taxes that would imply you made $100,000.
Focusing too much on investments with low tax implication might come with its own risks. That being said you might want to consider paying more taxes for more net worth and less heart burn, than paying less in taxes for less net worth and more headaches.
Interest & Income are 100% taxed at your marginal tax rate.
Dividends are taxed more favorably due to a “dividend tax credit”. Without getting in to too much detail, only 75% of dividends received are taxed.
Under the current income tax system, income earned by corporations is taxed at the corporate tax rate. If dividends are paid out to individuals after corporate taxes, it will be taxed again, at the individual tax rate. Without any other measures, this would result in double taxation. To address this, the tax system uses two mechanisms: the “gross up” and the “dividend tax credit”.
Dividends are grossed up by 25% (this is intended to approximate the before-tax income of the corporation) so that the “dividend tax credit” is assessed on 125% of the amount of the dividend payout. So, essentially what the “dividend tax credit” ensures is that the money already taxed is not collected on again.
Capital Gains are taxed most favorably, because they are not fully taxed. Currently, only 50% of capital gains are included as income when calculating annual tax returns.
Many investors do not account for the effects of inflation in their financial decision-making; they forget to factor in the dramatic impact on what ultimately ends up in their hands. Investors should see inflation as money cancer, as it makes the purchasing ability of your money weaker over time.
Deductibility vs. Deferability
A deduction is an amount of money you can subtract from your gross income before you calculate taxes. The more you can reduce your gross income with deductions, the less the amount you’ll pay income taxes on. It PAYS to deduct. Example: Moving expenses, tuition, charity donation...
A deferral means that you can “postpone” payment of current taxes until a later date in the future, commonly at retirement. The great thing about deferring taxes is the likelihood that you will be in a lower tax bracket when you do have to pay taxes on the money. Example: Your RRSP contributions.
Each person has their own special circumstances or considerations that will affect your investment preferences.
Remember: Each investor profile will require a somewhat different approach to investing. In each case their time horizon, risk tolerance, personal finance, investment knowledge, investment style and taxes considerations will determine your investment comfort zone.
100 Year Rule
A traditional rule of thumb is to use your age as a percentage to invest in Fixed Income and Cash and 100 minus your age should be invested in Equities. As you age more money goes towards Fixed Income which theoretically is a safer investment as you get closer to retirement.
Consider this regarding the “100 Year Rule”:
The younger you are, the more time your investments have to recover from a stock crash. In this respect, investments are a bit like people. If a 20 year old and an 80 year old fall on concrete sidewalk, odds are higher that the younger person will fully recover.
Remember: Use your age as a percentage of money to be invested in fixed income investment and then subtract your age from 100 and invest the resulting number in growth investments.
The “Theory of Decreasing Responsibility”
Conversely I would argue that the “100 Year Rule” has a flaw. The typical financial life cycle of most families follow the “Theory of Decreasing Responsibility”. What I mean by that is:
When you’re young...you may have young children to support, a new mortgage, a car payment and an army of other obligations. Yet you haven’t had time to accumulate a significant cash estate through savings and investments and are not yet financially independent. This is when the loss of your hard earned money could be devastating for your family; therefore, investing in a more conservative way would be suitable.
When you’re older and close to retirement...your children might be out of the house, your mortgage and car is paid off and you most likely have fewer financial responsibilities. By now you've had several years to accumulate a significant cash estate through savings and investments and you are financially independent. This is when technically, you no longer have income that needs to be protected for future obligations and you could afford to be more aggressive with your investment choices. Wrong! This is when the loss of your hard earned money could be devastating for your retirement years; therefore, investing in a more conservative way would be suitable.
Remember: As your age, interests and economic circumstances change so will your investment profile.
How to get there from here (Asset Allocation & Investor Profile correlation):
What is your Investor Profile?
Here numerous advisers will go through a questionnaire covering all the aspect mentioned earlier in this chapter to assess your investor profile. Truth is many people mistakenly self asses as an aggressive investors and the only person benefiting from that is your broker when he washes his hands of your losses in the stock market by deflecting his responsibility based on the premise you knew these risks.
___ Where you are in life?______________________________________________________________
___ What’s your Investment Time Horizon?_________________________________________________
___ What’s your Investment Objectives?___________________________________________________
___ What’s your Risk Tolerance?________________________________________________________
___ What’s your Personal Financial Health?________________________________________________
___ What’s your Investment Knowledge?___________________________________________________
___ What’s your Investing Style?_________________________________________________________
Are you a Very Conservative Investor; AKA “Old school” investor who generally invests in interest paying investments like GIC’s
Are you a Conservative Investor; AKA “Real” investor who generally invests in Income generating investments
Are you a Moderate Investor; AKA “Easy Going” investor who generally invests in Balanced funds
Are you a Aggressive Investor; AKA “Impatient” investor who generally invests in Equities
Are you a Very Aggressive Investor; AKA “Speculator/gambler” who generally invests in Derivatives and short term bets
My personal observation in my many years working with people is that statistically speaking 90% of the population, especially if you don’t work in the field, has limited investment knowledge, limited financial resources and consequently are risk adverse; anyone who works hard to save their money and sees their savings evaporate is fearful of losing what is left. If you are young with lots of fiscal responsibilities or if you are someone getting ready for retirement you should have a conservative approach with investments. If you haven’t won the lottery or you’re not expecting a huge inheritance, chances are you should be focusing on your biggest vacation yet… your retirement.