Brian Beamish FMA, FCSI
Managing Your Portfolio Professionally
How to get you from here to there.


Introduction


This is an introductory seminar on securities portfolio management. This information is meant to be a basic introduction to the general concepts behind financial planning with regard to investing and by no means represents a thorough examination. I strongly encourage feedback and hope to hear all of your questions, as all of these seminars are an ongoing work in progress.


What kind of investor are you?
Introduction to Asset Allocation
The Efficient Frontier
Minimize Costs
Creating your plan
Three examples of plans

We start this seminar with the most important aspect of investing, knowing your self as an investor. Anyone new to investing should start here, as getting the basics down first will help on your road to financial success. Once we have an idea of who you are (as an investor) and where you want to go, we determine the most risk avers path to get you to your goal. We compare historical performance of various assets and briefly touch on the significant effects of diversification in achieving desired performance. With these tools we move on to creating an investment plan custom built to your needs, implementing the plan and a schedule for reviewing the plan. Finally, at the end of this seminar we look at three, distinct investor profiles and how they might set up a professional managed portfolio.


What kind of investor are you?

back to top


One of the most important rules of successful investing is to identify and stay within you investment risk profile. Your investment risk profile is the amount of investment risk you are willing to take for the prospect of earning a higher investment return.

To show how important getting the right risk reward profile can be; you should consider that $10,000 invested for 10 years at 4% compounding will grow to $14,802, but the same $10,000 compounding at 8 % for 10 years will become $21,589. The catch is that higher performing investments are more likely to show higher investment volatility or risk, and so are not suitable for all investors. Finding your correct investment risk profile means achieving the highest returns you can while still sleeping soundly at night.


1: If higher returns on my investments were needed to meet my goals, I would:
Feel comfortable with investments that might occassionally decline in value in a given year.
Feel comfortable with investments that might have frequent declines in value in a given year as long as the average return is higher over time.
Not feel comfortable putting my money into investments that could decline in value in any given year.

2: If an investment that I owned dropped in value by 10% while other similar investments did not, I would most likely be inclined to:
Want to move my money into another investment.
Consider buying more of the investment.
Leave things as they were.

3: If I were on a TV game show and I were given three choices, the choice I would mostly likely make would be:
A one-in-five chance of receiving $10,000 if I could guess which one of five possible boxes had the $10,000 hidden in it.
A guaranteed $1,000, combined with a 50/50 chance for an additional $2,000 if I could guess which one of two possible boxes had the $2,000 hidden in it.
A guaranteed $2,000.

4: When I consider my overall investment situation, the most important objective for me is to:
Achieve long-term growth.
Preserve asset values.
Balance current income needs and long-term growth.

5: If I were investing $20,000 today to meet a critically important goal occurring twenty years from now, I would feel most comfortable investing it in:
A government treasury bond.
A fund consisting of only investment grade corporate bonds.
A fund consisting of only stocks of small and medium sized companies.

6: When it comes to investing, I am most comfortable with investments that:
Have some chance of short-term loss, but offer a moderate opportunity for long-term growth.
Have a higher chance of short-term loss, but offer the greatest opportunity for long-term growth.
Are stable and protect against loss, even if they just barely beat inflation.

7: I am offered a chance to buy into a new technology venture for a $5,000 investment. The venture has a 50% chance of paying back $25,000 within 5 years and a 50% chance of losing my entire investment. If I had the $5,000 available to invest, I would:
Definitely take a pass; it is too risky for me.
Jump at the opportunity; the upside far outweighs the downside.
Give it very serious, thoughtful consideration.

8: How many years from now do you plan to use these funds?:
0-3 years.
4-7 years.
8 or more years.


The answers to these seven questions should give you an idea of how much risk you, as an investor, are willing to take [please ask for the grading scale if doing this survey on your own]. If we asign a value from 1 to 9 (1,2,3 get low risk score: 2; 4,5,6 get medium risk score: 5; and 7,8,9 get high risk score:8) for each answer and then add these scores together we can come up with a total risk survey score (minimum 2 x 8 questions = 16, maximum 8 x 8 questions = 64). We can then plot this number on a scale to visualy see where you sit on the risk spectrum (refer to diagram 1 below). Furthermore, idenfiying where you sit on the risk spectrum should also produce a fairly accurate risk profile of you as an investor.



A Brief look at Asset Allocation

back to top

There are so many products for investors to consider buying how does one know where to start. First off, it is important to understand that not all asset types perform the same way. Some have higher risk but are accompanied with a higher reward while others have relatively low risk and therefore a lower reward. For illustrative purposes, here is a performance chart of six different asset classes over a two year period from both the bullish and bearish perspective. Coupled with the charts is a histogram table of the same performance.








source: stockcharts.com

Some simple conclusions; small caps can dramatically outperform and under-perform, interest paying assets tend to be stable and the effect of a rising or falling Canadian dollar can dramatically effect international returns. Each asset category has its day in the sun as we move through the economic cycle. Because of this consistent difference in performance an investor should never own just one or two of these sectors.

It cannot be said enough, since the exactly future is unknowable your portfolio needs to be a blend of each of these components. Unfortunately, by human nature, many investors end up owning far more higher risk equities at the top of the cycle simply because things look so rosy and nothing could possibly go wrong. The stocks they did own were often 'growth' oriented which made for a bigger problem. Asset allocation's sole purpose is to prevent this from happening. And simply put, consistent review (and re-balancing if necessary) of asset allocation is the hallmark of a professional approach to portfolio management.


The Efficient Frontier

back to top


Every investor is an asset allocator to a certain degree. The question is, how to best allocate your assets based on what kind of investor you are and what it is you want to achieve. One model, the effecient frontier tries to address this very question. First conceived by noble prize winning economists, Harry Markowitz and Bill Sharpe, it is a graphical representation of risk vs. return and portfolio performance based on various combinations of different performing assets. Markowitz showed that the best performance combinations created a region bounded by an upward-sloping curve, which he called the efficient frontier. The optimal portfolios plotted along the curve have the highest expected return possible for the given amount of risk. Every investor lies somewhere along this curve and it is your personal risk/reward threshold that defines exactly where you sit. To find this point on the frontier all that is required is a basic understanding of your goals, your time horizon and your risk tolerance (if unsure, working with a financial planner will help in determining these variables). For example, a young investor with a long time horizon may own fewer bonds then equities. As well, investments may include more speculative issues such as small caps, options and warrants. Conversely, an older investor (concerned with capital preservation) may allocate a far greater percentage of his assets towards fixed income then to equities. Not wanting to loose equity exposure this investor may consider convertible bonds or equity-linked notes to ensure their principal.


source: investopedia.com

In summary then, asset allocators strive to find optimal performance for the least amount of risk. The efficient frontier identifies all potential asset allocations and plots their performance based on risk. To create the optimal portfolio one needs only to find where they sit on the frontier and replicate the portfolio.


Minimize Costs

back to top


Costs can have a dramatic impact on investment performance. In fact, the diference between returns on assets that are charged a 'Management Expense Ratio' (MER) and those that are not can literally be tens of thousands of dollars over the lifetime of an investment. Of course, owning the stock of a single company has no annual costs associated with it (other than commissions paid at the time of purchase and sale) but what if an investor wants to reduce their risk by buying a basket of stocks? For many years investors had no choice when it came to paying MER's. Canadian's wanting to buy a diversified portfolio of stocks had to choose from a small list of Canadian based mutual fund companies. These fund companies set their MER's at very high levels since there was no competition in the market place. Furthermore, an appendix to the North American free trade agreement made it illegal for Canadian citizens to buy non-canadian mutual funds. The average MER charged ranged from a low of 1.5% to as high as 3%.

With the advent of Exchange Traded Funds (ETF's), investors now have choice when it comes to buying a diversified portfolio of Canadian stocks. As the name implies, Exchange Traded Funds offer the same diversification as many mutual funds, are listed on the Toronto Stock Exchange and are very liquid. They are literally a basket of stocks (usually reflecting the components of an underlying index) held in trust that is 'marked-to-market' every day. The most impressive aspect of ETF's though, is the fact that the MER's are very low.

To support the idea that lower MERs directly translates into greater performance, Advisor.ca published a report in their May 2005 issue of Advisor's Edge (pdf file) that looks at the historical performance of managed funds and their respect MER's impact on performance. Their conclusion, "the long-term, buy-and-hold investor for whom investment funds are designed and to whom they are marketed is also the person most harmed as high expenses exact their inevitable toll on long-term performance. Even more than the month-to-month performance-chaser, the long-term buy and hold investor is best served by eschewing higher-MER funds in favour of their lower-MER peers."

In summary then, when investing for the long-term it is imperative to diversify holdings but at the same time keep costs as low as possible. The greater your diversity, the lower the risk. The lower the annual costs of ownership the more money in your pocket when it is time to sell. With this in mind, it is only natural ETF's should become the favored investment vehicle for Canadian investors.


Creating a Portfolio

back to top



1. Define investment objectives, determine time horizon, draw up a personal risk profile.


2. Create investment policy statement.


3. Determine over-all asset allocation based on objectives, time horizon and investment policy statement.


4. Determine sector allocation by product type based on objective and personal risk profile .


5. Allocate assets SLOWLY based on above criteria.


5. Monitor portfolio performance for anomolies, review and rebalance semi-annually.



Three Portfolios

back to top


  • Client A Young professional (medium/aggressive)

Total Assets: $250,000 ($150,000 home, $75,000 business/personal assets, $75,000 investments)

10% commodity exposure: $25,000

1st Efficient Frontier (asset class): 75% stock ($18,750), 20% fixed income ($5,000), 5% cash ($1,250)

2nd Efficient Frontier (asset type): 50% venture, 25% intermediate, and 25% conservative

Recommendation:

Equity

$8,750 venture capital

$5,000 intermediate

$5,000 conservative

Fixed Income

$5,000 bond or convertible security

Cash

$1,250 Money Market Fund

  • Client B Peak earnings years (medium)

Total Assets: $500,000 ($250,000 home, $125,000 business/personal assets, $125,000 investments)

10% commodity exposure: $50,000

1st Efficient Frontier (asset class): 55% stock ($27,500), 40% fixed income ($20,000), 5% cash ($2,500)

2nd Efficient Frontier (asset type): 33% venture, 33% intermediate, and 33% conservative

Recommendation:

Equity

$9,075 venture capital

$9,075 intermediate

$9,075 conservative

Fixed Income

$20,000 bond or convertible security lader

Cash

$2,500 Money Market Fund

  • Client C Retirement & Capital preservation (conservative)

Total Assets:$1,000,000 ($500,000 home, $250,000 business/personal assets, $250,000 investments)

10% commodity exposure: $100,000

1st Efficient Frontier (asset class): 20% stock ($20,000), 75% fixed income ($75,000), 5% cash ($5,000)

2nd Efficient Frontier (asset type): 25% venture, 25% intermediate, and 50% conservative

Recommendation:

Equity

$5,000 venture capital

$5,000 intermediate

$10,000 conservative

Fixed Income

$75,000 bond or convertible security lader

Cash

$5,000 Money Market Fund