By David Trahair
There’s a good rule of thumb when it comes to asset allocation decisions: you should have at least your age in safe fixed income products.
It’s RRSP season again and that means you are probably wrestling with the same old problem — where the heck do I get the money? I can’t help you with that one, but let’s assume you are successful in making a contribution. The next logical question is, what should you invest in?
As I am not a licensed investment adviser who can make specific recommendations, let’s talk about the subject in a general sense.
One of the key investment decisions is what percentage of your portfolio to allocate to equities versus fixed income products. Risky products such as stocks and equity ETFs come with potential high (or low, or even negative) returns, and safe fixed income products such as GICs and government bonds come with positive (but low) returns. How do you make your asset allocation decision?
Generally I am not a fan of rules of thumb when it comes to personal finances because each of our situations is as individual as our fingerprints. And because we are in different situations, a rule of thumb may give a misleading answer.
Having said that, there is one rule of thumb related to asset allocation that I do like. It says that the percentage of your portfolio allocated to the stock market should not exceed 100 minus your age. That means a 30-year-old should not have more than 70% in the market and an 80-year-old should not have more than 20%. Looked at another way, you should have at least your age in safe fixed income products.
Remember that your asset allocation decision should be made on your entire portfolio, not just this year’s contribution.
Let’s focus on the equity portion of your portfolio and assume you want to use a passive investing strategy using low-cost ETFs to mirror the market.
Where in the world are you going to invest? First, consider diversifying your equities beyond Canada. There are many reasons for this, including the fact that the Canadian stock market is heavily weighted in resource (and financial) stocks. The recent crash in oil prices has led to low returns for the overall Canadian market over the past few years and you would have suffered if all your equity eggs were in the Canadian basket. How about the US?
Let’s look at how the Canadian market has done versus the US market over the past 30 years. Here is a chart of the average annual rates of return of the Canadian stock market as measured by the S&P TSX composite total return index and the US market as measured by the S&P 500 total return index. Note that both these indexes include the effect of reinvested dividends and assume annual compounding of the investment return
As you can see, the US market has beaten the Canadian one by a significant amount over the past 10- and 30-year periods, and they have been essentially equal over the past 20 years.
But the S&P 500 returns are in US dollars. Since we have to report investment activity in Canadian dollars, our returns should use index figures converted to Canadian dollars. Below is the chart after conversion of the relevant S&P 500 index figures to Canadian dollars at the prevailing exchange rates, and the revised premium over the TSX.
Changes in the foreign exchange rate can have a significant effect. For example, the US dollar measure returned 8.5% over the past decade versus the Canadian dollar measure of 11.15%. That’s a 2.65% annual increase due to the fluctuations in the rate.
While it seems prudent for you and your adviser to discuss allocating at least some of your portfolio to the US, proceed with caution as there is no guarantee that future returns will be as rosy. Many factors could impact stock market returns going forward besides foreign exchange fluctuations, including rising interest rates, the risk that we are in bubble territory due for a correction and the eccentric political and economic policies of the person in charge of our neighbour to the south.
David Trahair, CPA, CA, is a personal finance author and speaker (www.trahair.com).
This article was originally published in the February 2018 issue of CPA Magazine.