Asset Allocation – Include Future Contributions?

by Mike Holman

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One of my favourite investment topics is asset allocation – trying to figure out what your division between stocks and bonds should be in your portfolio.   I read a comment on this idea recently written by the excellent blogger Michael James who writes an excellent financial blog.

Normally when you are trying to figure out your desired asset allocation you consider your existing portfolio.  If you have $100k then you might decide to go with 70% stocks and 30% bonds.  Within those major asset classes you would probably have more detailed asset classes such as Canadian equities, US equities etc.

This approach works quite well for investors who have a fairly significant portfolio assembled.  But what about someone who is just getting started?  They might be in the situation where their portfolio is quite small but they are making large contributions to it.  An example could be someone who has just paid off their mortgage and now has quite a bit of extra cash to contribute to their retirement savings.

Does asset allocation matter if your contributions are a significant percentage of the portfolio?

I would say no.  If an investor has a portfolio value of $5,000 on Jan 1 and is planning to contribute $1,000 per month then it’s not worth worrying about keeping his portfolio at the perfect allocation.  One of the main reasons for asset allocation is risk management – either you want to protect your assets or are willing to risk them for a greater future reward (or something in between).

If you are in this situation then I would still consider coming up with some sort of asset allocation model (ie 75% stocks, 25% bonds etc) although it’s not really necessary in the early stages.  If you are buying securities with transaction fees such as stocks or exchange traded funds then it might be cheaper to just buy a lot of one investment at a time.   Even if you are buying index funds or managed mutual funds which don’t have transaction costs then don’t worry too much about the allocation until you have enough money to assemble a proper portfolio.

At what point should the asset allocation matter?

Tough to say – I would suggest that rather than think of a dollar figure – a ratio of yearly contributions to portfolio size might be more meaningful.  From a risk point of view – someone with an investment portfolio of $10k and annual contributions of $20k probably isn’t that worried about the original $10k from either a safety standpoint or a performance standpoint.  It just doesn’t really matter much in the beginning.

On the other hand if an investor has $20,000 and is contributing $1500 per year then they should concern themselves with designing a proper portfolio since they are at a point where the contributions are a small percentage of the portfolio.

Another factor might be the normal variances of the portfolio – if you assume a possible range of -15% to +15% (in most years) for a mostly equity portfolio then if the 15% estimate is larger than your contributions then that might be another point where your asset allocation plays a bigger part of the risk management rather than your contributions.

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{ 6 comments… read them below or add one }

1 Dividend Growth Investor

Actually as a person who actively contributes toward my brokerage accounts ( both taxable and tax exempt) I tend to add more to assets which have a lower allocation than what I would like them to have. I don’t rebalance as I simply add more to asset classes that are underallocated.

Example: If my portfolio is worth $100 and due to the stock market “correction” my stock/bond allocation is 50/50 while I would like it to be 75/25, by adding $150 in stocks in 2009 I might have achieved my target allocation by year end.

2 Michael James

Thanks for the mention. In your example of someone just starting out saving $1000 each month and having a target allocation of 75/25, one approach is to just build up cash for 3 months at a time and make ETF purchases of $3000 at a time. The first two purchases could be stocks, and each subsequent purchase would be whichever asset class is furthest under the target allocation (similar to Dividend Growth Investor’s description). This way there is only one commission paid every 3 months.

3 Canadian Capitalist

Thanks for the link. I don’t disagree with your viewpoint that variations in asset allocation isn’t worth worrying too much over. And when starting out variations are sometimes bound to be huge.

“Even if you are buying index funds or managed mutual funds which dont have transaction costs then dont worry too much about the allocation until you have enough money to assemble a proper portfolio.”

I think you meant “deviations in asset allocation” in the above sentence.

I suppose it is very important to have a well-thought out asset allocation targets whatever the size of the portfolio and some variations (which maybe large when starting out) are not worth sweating over.

4 Silicon Prairie

It all depends on what “a lot” is to you. I started out my automatic investments with TD e-Series funds, using contributions divided according to a simple allocation. I’m still using the same funds until it grows a bit larger and I can introduce new asset classes and start looking at ETFs (buying less frequently to reduce commissions).

At the beginning, investing amounts that match your allocation (which could be expensive using ETFs) will make a much bigger difference. When one of your funds is $10 off the target allocation it won’ t be very noticeable; when it gets to $100 some people will take notice (and maybe invest a little more ot make up the difference); when it’s a difference of $500-1000 a lot of people will probably want to rebalance but for a large enough portfolio that can still be a small percentage.

For someone starting out it’s probably worth rebalancing or making an extra investment every 12-18 months if the difference is over $20-50, if only so they can get in the habit. As long as it doesn’t involve extra comissions you might as well do it early.

5 MoneyEnergy

This is an interesting issue to consider. Asset allocation is definitely important for risk management and portfolio protection. But I think you’re right, in the beginning it may not matter as much (except insofar as any new contribution might have an undue influence on your existing portfolio simply because there is less in it). Nevertheless, it’s good to have your ultimate asset allocation in mind and keep striving towards it, I think.

6 GabyA

Like any statistical measurements, you are going to get wild swings when you are starting on your savings. If you’re not investing in some low MER funds like TD’s e-funds, I think you should ignore the deviations from your goals until you have enough to offset the trading commissions. Say you have 1/3 stocks, 1/3 REIT’s, and 1/3 bonds and you’re contributing a thousand a month, put the full amount in a group every three months, and at the end of, for example two years, start making two trades, one to the class that’s scheduled to get the money, and enough to the class trailing the most. Some say it’s not even worth doing it this way if your asset class hasn’t deviated much more than a certain threshhold (e.g. your 33%/33%/34% allocations becomes 38%/31%/31%, but it’s still close to enough of 1/3, so don’t worry).

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