If you are starting out, keep it simple. Consider, but don’t let it paralyze you.
For most people starting out with investing, you should keep asset allocation simple, as described on the previous page. You don’t want to miss time in the market by agonizing over nuances. Further, most of those nuances don’t matter until you have a larger net worth. Get started, build experience and assets, then look at these other issues.
For those who have many assets, think about how they mesh together as a whole.
You may have a variety of other investments that make up your overall portfolio. These could include managed investments, a pension, whole life insurance policy, or business. These are all assets that you can use. So, to put your DIY investing into that bigger context could be important. If you have an abundance of safe assets, you might be able to take more risk. If you have other risky assets, you may want to play it safer with your DIY investments. Do they share risks and aren’t providing you with the diversification you want?
Even if you have multiple assets, you may want to treat your DIY investments separately if:
- If it is either a very small or a very dominant portion of your overall wealth. Not worth the bother.
- You cannot readily put your DIY investments into context with the bigger picture. If you will freak out by a loss in your DIY accounts even though your other assets are buffering it. Don’t bother. You need to have a safe DIY asset allocation that you can emotionally stomach regardless of how much other wealth you have.
Use The Portfolio Blender Calculator To Help You
To help with the math, as you consider how other assets could mesh with your DIY portfolio, you can try the Portfolio Blender Calculator. It works best on a desktop or tablet.
Click the image or the above hyperlink to open it in another tab and use it as you go through this page. There are also hyperlinks later in the text, but you don’t need to open it multiple times. Do it once and fill it as you go.
In The Wrong Spot?
How Other Assets May Fit Into Your Overall Asset Allocation
Other Managed Investments or Funds
After seeing the evidence of passive vs managed investing returns, some people rip off the bandage and bravely forge ahead with DIY index investing. All in. They may still use a fee-only advisor to help with occasional portfolio reviews and financial planning. Others want to do some DIY investing, but also find that a full-service financial advisor also provides them with good value for the fees. The right answer is different for everyone.
It is not uncommon that after doing a deep-dive, like you have in this series of pages, that you come up with a different asset allocation than you did with your financial advisor.
Reflect on whether that difference is because:
- They are more objective and experienced
- They were pushing you towards certain products
- You now have a better understanding of what they were talking about when they did your risk tolerance evaluation than you did at the time. You would answer their questions differently now.
- They didn’t ask about all of the details that you have now considered.
If holding a mix of DIY and management investments, remember that it is all your money.
So, you need to consider all your investments when thinking of your asset allocation and risk tolerance. For example, if the asset allocation from your risk tolerance and capacity assessment is 60:40 stocks to bonds, then aim for that overall asset allocation. You may want to invest differently with your DIY portfolio to counter-balance what is in your managed one.
If doing that, remember that you may see more or less volatility in your DIY investments based on the asset allocation you chose relative to your managed investments. It is to be expected and not because you are doing it wrong. If you cannot do that (volatility hits emotions and emotions are not logical), then stick with the stock:bond allocation below your risk tolerance for your DIY investing. Consider increasing the risk in your managed investments instead. Then, your advisor should try to talk you off the ledge during a market downturn.
When using the Portfolio Blender Calculator, you can select to include managed investments and private equity. Enter the allocation and value of those investments in the Managed Funds tab of the calculator.
How A Pension Fits In With Your Other Assets
Pensions are an important asset and part of your overall investment portfolio. A major goal for most people is to fund their retirement and a pension (if you have one) is a key part of that. You should consider whether and how to include them in your overall asset allocation.
Employer sponsored pensions can be defined benefit or defined contribution.
If it is defined benefit, then it would definitely fall towards the fixed income (safe) end of the investment risk spectrum. That assumes the pension is well managed and funded. These are harder to come by these days (outside of the public service) because the employer assumes the risk. The Canada Pension Plan also falls into this category – a well-funded and run pension with a safe but low return. Defined benefit pensions would be analogous to bonds for your asset allocation.
With a defined contribution pension, the risk depends on what the pension holds. You can likely get that information from your pension provider. You may have choosen some options from managed funds or as one managed fund. Either way, you should be able to find out the proportion of equity to bonds/cash.
Can you consider a pension as a “bond-like” asset in your asset allocation? Maybe.
Condition #1: You must be able to readily remember and be soothed by your pension.
First, you need to be able to remember that you have the pension when you see your investment portfolio value fluctuate. You don’t want to take more risk in your DIY investments because you are counting your pension as a safe asset if you forget and get freaked out by the increased volatility on your investment statement. This is may be challenging in practice. You see your investment balances much more frequently. In contrast, the value of your pension is not readily apparent and we usually do not dee it frequently. Our emotional beast is simple and may not connect the two easily.
Condition #2: You must have some sense of your pension’s value.
The value of your pension is often not readily apparent. You don’t get a balance statement often and it can be hard to translate a pension benefit down the road into a dollar value now.
For a defined contribution pension, it may be simple. You can get the value of your investments in the pension.
For a defined benefit pension, it is more complicated. You may need to pay the pension provider to do an assessment and valuation. That is not something most people pursue unless it is needed as part of a divorce or estate settlement. Consider doing this, if you think precision is important for your situation. However, we can use some rules of thumb to get a general value.
Estimating the value of a defined benefit pension.
The basic prinicple is to attach a value to the income stream. You may get this intermittently if your pension sponsor reports the commuted value of your pension to you.
If not, then one rule of thumb to value a pension or other stable income-flow is about $18K for every $100/month ($1200/yr) of cashflow. This rule of thumb equates to a 6.6% “safe withdrawal rate”. That is higher than the much discussed “4% rule”. However, with a DB pension, your sequence of return risk is spread out amongst all of the pension participants who contribute and draw on the pension over different time frames. So, a higher rate than 4%/yr may be reasonable.
I would use the value if I took the pension today in estimating its value and not what it will hopefully be in the distant future when I take it. A lot can happen to employment or a pension between now and then.
Estimating the value of your Canada Pension Plan (CPP)
You can get a record of your contributions and current estimated benefit here. Revenue Canada also has a CPP calculator to estimate your benefit if you take a guess at your earnings over 5 year blocks of your life.
Don’t sweat this too much.
You do not need a precise valuation of your pension to use it as part of your asset allocation. A rough guess is likely better than ignoring your pension. However, if you have a really large investment portfolio and your only pension is CPP, then the income stream and value of CPP may not be worth worrying about.
Condition #3: Be aware of and accept some limitations.
A pension is not a substitute for bonds for rebalancing purposes. Bonds not only fluctuate in value less, they also help you rebalance your portfolio. If stocks crash, bonds usually either fall less or even rise in value. So, you can sell some bonds to buy equities at a discount. You can’t sell part of your pension to do this. Whether this matters or not is debatable. During volatile periods, rebalancing between stocks and bonds can enhance performance. During an uptrending market, rebalancing controls risk but decreases expected returns to do that.
When using the Portfolio Blender Calculator, you can select to include any of defined contribution, benefit, and/or Canada Pension plans. For defined benefit plans, it will estimate value using the rule of thumb described above.
How does whole life insurance fit into asset allocation?
Whole life insurance is definitely not a required financial product. However, some may have it.
For most physicians, particularly those early in practice, a simple and cost effective approach is term life for life insurance needs and ETF index investing for investment needs. However, whole life insurance is marketed quite aggressively and end up buying into it. It comes dressed in different guises like whole life, universal life, participating life, and infinite banking.
Whole life insurance is like a marriage, a long-term commitment and expensive to get out of. A small amount of whole life as part of a bigger portfolio can have some roles in estate planning. It is also one of numerous ways of minimizing the impact of the active-passive income small business deduction clawback. None of these uses are a major concern until mid-career and their are alternative options. It can be good, but most physicians should just date early in their careers.
Why you might consider whole life as “bond-like” as part of your asset allocation.
The return is pretty safe. You have a pay-out at death. Along the way, your whole life policy may have a cash value for the “investment” portion. To access that, you generally borrow against the policy’s value (and pay interest to the lender). So, you could use it in cashflow pinch. However, that may be neither cheap nor convenient. Since insurance policies must invest relatively conservatively and this is a pretty safe return, expect a low return. Yes, it will be tax-free – but low.
In summary, expect a stable but slow growth rate in the range of what to expect from bonds.
There are limitations to considering whole life as “bond-like”.
This is very similar to the issues with a pension. The policy is not particularly liquid. It also does not move inversely to equities like government bonds often do. The value of the insurance may dampen volatility, but to a lesser extent than bonds. While you could theoretically borrow against your whole-life policy in a market downturn to buy equity, it is not as straightforward for rebalancing as a bond fund would be. Same as using it to meet a cashflow need if you get an unlucky sequence of returns around retirement.
When using the Portfolio Blender Calculator, you can select to include whole life insurance policies in your portfolio asset allocation and enter their cash value in the insurance tab of the calculator.
If you own a business or income property that you could sell.
Many business owners and entrepreneurs have most of their net worth tied up in their business. However, most also compartmentalize that separate from their investment portfolio. How to treat a business in asset allocation is tricky, but worth considering. The are a number of factors to consider.
How does the business contribute to your wealth?
Most businesses serve as an income stream. Is it active or passive?
That would be analogous to dividends or interest from a stock/bond except that you have to work for it. If the business requires very little direct input from you, then it is pretty passive and could possibly be seen as an investment income stream and part of your portfolio.
If the income is tightly tied to your labor, then it is a job. You just happen to own your job. This is most physician practices. Some might consider their job and its stability when determining their risk capacity, but not as an asset in their portfolio.
Some businesses have capital value. If so, would you sell it?
A business can have capital value if someone would buy it. That value lies in the physical assets (equipment, real estate, inventory) and the revenue stream (client base). If the client base is easy to come by (like patients) and the equipment depreciates quickly, then there is not much value in the business. This is most medical practices that rely on public funds for payment.
On the other hand, if the physical assets and clients are tough to come by, the business may have value. The value of the future income is discounted according to how uncertain it is. This is subjective and you don’t really know the value of the business until you successfully sell it. You would also need to consider the cost of brokerage fees to sell the business. That said, you could consider net value as part of your portfolio if you plan to sell it at the time you start to rely on your portfolio to live off of.
Making a rough guess is likely closer than assuming it is zero. However, I would guess conservatively – even if I had my company professionally appraised. Personally, I know that I would have a bias to think my company is more valuable than it is, given how personally invested I would be.
If including a business: Is it more stock-like or bond-like? Is it cyclical?
There are two main characteristics to consider for the business. How volatile is its value and how does that value correlate with publicly traded stock market values? In other words, how cyclical is the business.
On the other hand, if I owned a service-based business that people use in good times and bad, it may behave differently. If it were resident rental properties, they may also behave differently depending on the demographics of the renters and the interest rate movements in response to changing economic conditions.
While non-cyclical businesses and property may be less volatile, it is important to remember that during major economic/market crashes, the correlation of most assets goes to 1. They all move down, but the magnitude of the move can vary. The hard assets of a business may have more stable value (“bond-like”). Future income is much more volatile (“equity-like”), whether it is closer to consumer staple end of the spectrum or not.
The problems with including a business as part of your asset allocation.
If you read the previous sections, you probably realize that it is likely important to consider the value of a business. However, it is also readily apparent that it is tricky to know the value of a company and how it behaves compared to stocks or bonds. Additionally, a business is not very liquid and cannot be effectively used for rebalancing.
The danger of not considering your business is over-concentration.
Something else a business owner may realize, if they consider their business as part of their asset allocation, is that they have a concentration of risk tied to their business. There is often a bias towards the business and possibly an underestimation of risk. This is because the owner is personally invested and has more control over it than they do over publicly traded companies. This is choosing specialization instead of diversification to manage their risk. That can be very effective is they are skilled and their market conditions are very stable (and will remain so). The risk of specialization rises the more that factors outside the owner’s control influence the business. Those factors may be unforeseeable. To counter that risk, a business owner may look at ways to use the equity in their business to buy more diverse investments.
When using the Portfolio Blender Calculator, you can select to include up to two different businesses in your portfolio allocation. Enter information about the business income, assets, and marketability to estimate value.
Stock options or company stock from your employer.
Some employees get stock options or company stock from their employer. There may be some price and tax advantages to that. However, this also carries the same issues as a business owner in terms of concentrated risk. In fact, it can be amplified by the fact that their job security may drop at the same time as the stock price. They also have less control over their employer than a business owner. So, diversification through gradually selling company stock and buying more broad investments is usually warranted.
When using the Portfolio Blender Calculator, you can add the value of company stock that you actually own into a line in the DIY investments section. Classify it as 100% equity.
Equity in your home or personal real estate.
Most Canadians point to their personal real estate as their most valuable asset. It has characteristics of both an asset and a consumable. It is also debatable whether to include it as part of your overall portfolio.
Personal real estate is a consumable in the sense that it provides utility as a shelter. If you sell it, then you must pay for shelter elsewhere. So, if I were thinking of including home equity in my portfolio, then I would only include the equity that is freed up and not spent for new shelter. Further, that only applies if I were planning to downsize and release that equity at the time I was going to start drawing from my portfolio.
The further that time is in the future, the less likely I would be to consider my home equity. Plans can easily change. Plus, the reason to hold stabilizing assets in your portfolio is to keep your emotions in check. It is a mental leap to consider your home equity when you see your liquid investments crater. Even moreso the further into the murky future your need to peer into for that home equity.
Over long periods of time, home prices have risen 1-2% above the rate of inflation. In that sense, personal real estate can be considered an asset that is very similar to bonds. So, it could be reasonable to think of home equity that will be released as “bond-like”. Subject to the limitations mentioned above. Like other illiquid assets, personal real estate is not very useful for rebalancing and can’t fill that role in a portfolio well.
When using the Portfolio Blender Calculator, you can add the value of home equity and/or a personal use property that you are willing and able to sell if needed by selecting the personal real estate tab.
After considering how the different types of assets that you have can be accounted for in your portfolio, you may decide to use some, all, or none of it. In case you missed it, here is a portfolio asset blender that you could use if you want to try.