Latest / How Canadian Markets Work / Episode 95: Asset Allocation (The Master Lever)

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Episode 95: Asset Allocation (The Master Lever) · How Canadian Markets Work

0:00
So I want you to just imagine waking up and realizing
0:02
you missed out on like $168 ,000. Right. Which
0:06
is a terrifying thought. Yeah. And not because
0:09
you picked the wrong stock or because you panicked
0:12
during a market crash, but literally because
0:14
of one invisible math decision you made 20 years
0:18
ago. Yeah. It's one of those things that just
0:19
silently runs in the background. Exactly. So
0:23
in our last deep dive, we talked about how diversification
0:26
is basically the only true free lunch in finance.
0:29
And we dug really deep into understanding your
0:31
actual capacity for risk. But today, we're taking
0:35
a step back. We are looking at the single most
0:38
consequential choice you will ever make for your
0:40
portfolio. The absolute foundation of it all.
0:43
Right. We all know the classic definition of
0:45
asset allocation, right? It's just the split
0:47
between stocks and bonds. But what most investors
0:50
completely misunderstand is the actual mechanical
0:52
weight that split carries compared to, well,
0:55
everything else you do with your money. Oh, absolutely.
0:58
The decisions you make about this specific split,
1:00
they determine the vast majority of your financial
1:03
outcome. Which is wild to think about because
1:06
today's mission is to really look at the machinery
1:08
that actually drives your wealth. We're going
1:11
to explore why this Equity versus fixed income
1:14
split dominates your long -term performance way
1:16
more than like trying to pick the next Amazon.
1:19
Yeah, or trying to time the market. Right. And
1:21
we'll get into the fatal flaws of those popular
1:23
age -based math rules everyone uses and how you
1:28
can actually maintain your balance without accidentally
1:31
handing a massive tax bill to the government.
1:33
Because nobody wants to do that. Yeah. I mean,
1:35
people love to discuss the hottest tech stock
1:37
at dinner parties, right? Oh, yeah, always. But
1:39
the reality is, whether you hold Apple or Microsoft,
1:42
it matters a fraction as much as whether your
1:44
money is in equities or fixed income in the first
1:46
place. Yeah. It is the core of modern portfolio
1:49
theory. OK, let's unpack this because we're moving
1:52
from this abstract concept of managing risk to
1:55
the actual mechanics of how a portfolio behaves
1:58
in the wild. And I want to get away from generic
2:00
ideas like conservative or aggressive and really
2:03
look under the hood here. Why does this specific
2:06
split matter so much more than agonizing over
2:09
which specific company to buy? Well, to understand
2:11
the mechanics, we have to look at how these two
2:14
asset classes behave in relation to the broader
2:17
economy. So let's use a mechanical analogy here.
2:20
OK, I like analogies. Think of your portfolio
2:22
as a vehicle. Equities, your stocks, they are
2:26
the engine. Right, the power. Exactly. They provide
2:29
the forward momentum, the horsepower, the long
2:32
term growth you need to outpace inflation and
2:34
build real wealth. But fixed income, your bonds,
2:38
they are the shock absorbers. The shock absorbers.
2:41
Yeah, because you need the engine to get to your
2:42
destination. But without the shock absorbers,
2:45
hitting a massive pothole is going to destroy
2:47
the chassis, which in this case is your life
2:50
savings. So they play completely different roles.
2:52
But why do they behave so differently? I mean,
2:55
if the economy takes a massive hit, shouldn't
2:57
all my investments drop at the same time? Not
2:59
necessarily. And understanding the why here is
3:02
super crucial. Let's look at the underlying mechanism.
3:06
When economic growth stalls, companies make less
3:09
money and stock prices naturally fall. The engine
3:12
sputters. Right, the engine sputters. But what
3:14
happens next? Central banks typically step in
3:18
and they lower interest rates to stimulate the
3:21
economy. OK. Yeah, that makes sense. So when
3:24
new interest rates drop, the older bonds you
3:27
already hold in your portfolio, the ones issued
3:30
when rates were higher, they suddenly become
3:33
incredibly valuable. Oh, because they pay more
3:36
than the new ones? Exactly. investors flock to
3:38
them. So while your stocks are dropping in value,
3:41
your bonds are actually rising. That inverse
3:43
relationship is your shock absorber in action.
3:46
That is fascinating. Right. If you own two different
3:48
bank stocks, they both tank when the economy
3:50
struggles. But stocks and bonds operate on entirely
3:54
different mechanical triggers. Which brings us
3:56
to one of the most famous and apparently most
3:59
misunderstood pieces of financial research in
4:01
history. I know professionals just lose their
4:04
minds over how this study is quoted. What is
4:06
the Brinson study and what does the financial
4:08
media constantly get wrong about it? Oh, man,
4:11
it's the 1986 study by Brinson, Hood and Beebauer.
4:14
If you read financial news, you will inevitably
4:17
see an article claiming, like, asset allocation
4:20
determines 93 .6 % of your returns. I feel like
4:23
I read exactly that headline. You probably have.
4:26
The media uses this to suggest that if you just
4:29
pick the right ratio of stocks to bonds, your
4:32
final dollar amount is virtually guaranteed,
4:34
and that picking individual stocks doesn't matter
4:36
at all for your final wealth. But that's a misinterpretation
4:39
of the data. A massive one. What the researchers
4:42
actually found is that your asset allocation
4:44
explains 93 .6 % of the variation in your returns
4:47
over time compared to a benchmark. Wait, variation?
4:50
Yeah, variation. It does not explain the absolute
4:53
level of your return. OK, wait. Break that down
4:55
for me. Variation versus absolute level. How
4:57
does that actually play out in my brokerage account?
5:00
Let's say we both have a 60 -40 portfolio. 60
5:02
% stocks, 40 % bonds. OK, got it. And we experience
5:05
a really crazy year in the markets. In Q1, the
5:08
market surges. In Q2, it crashes. In Q3, it recovers.
5:12
A total roller coaster. Exactly. Because we both
5:15
hold the same asset allocation, the pattern of
5:18
our portfolios bouncing around that variation
5:20
will look almost identical. If we overlay our
5:25
charts, the squiggly lines will move up and down
5:27
an absolute lockstep. OK. That is what the 93
5:30
.6 % reserves to. Right. But here is the kicker.
5:33
You might have picked terrible underperforming
5:36
stocks for your 60%, and you end the year up
5:38
only 2%. Ouch. OK. Right. But I might have picked
5:41
phenomenal stocks, ending the year up 10%. The
5:44
pattern was the same, but the final dollar amount,
5:47
the absolute level, was vastly different. Oh,
5:50
wow. So the media uses this study to sell the
5:53
idea that you don't need to worry about the underlying
5:55
investments, just the broad categories. But the
5:58
study is really just saying that the asset split
6:00
dictates the roller coaster ride you are going
6:02
to take, not like how much money is in your pocket
6:04
when you get off the ride. Precisely. It dictates
6:07
the volatility you will experience. The shock
6:09
absorbers define how bumpy the road feels. Right.
6:12
And because the asset class split drives that
6:14
variation, that roller coaster, we really need
6:16
to look at exactly how massive the financial
6:19
consequences of that single decision can be over
6:22
a lifetime. It's huge. Yeah. So let's walk you
6:25
through the math on that $168 ,000 gap I mentioned
6:28
at the very top of the show. And just to be crystal
6:31
clear to you listening, we are using purely illustrative
6:35
historical averages to show the mechanics here.
6:37
These are not forecasts. Right. Definitely not
6:40
forecasts. But the math is staggering when you
6:43
stretch it over a long horizon. So let's assume
6:46
you invest $100 ,000 over 20 years. OK. If you
6:50
put it entirely in fixed income, all shock absorbers,
6:54
assuming a steady 4 % return, you end up with
6:57
about $219 ,000. OK, so more than double. Yeah.
7:01
Now, if you choose a classic balance split, 60
7:03
% stocks and 40 % bonds at an assumed 5 .8 %
7:08
return, you end up with about $309 ,000. OK,
7:12
a big jump. But what if you go all in, like 100
7:16
% equities? at a hypothetical 7 % return. Then
7:20
you land at roughly $387 ,000. $387 grand. That
7:25
is a gap of $168 ,000 compared to the all bond
7:29
portfolio. Exactly. Resulting from one structural
7:33
decision. You didn't have to research a single
7:35
CEO. You didn't have to predict a single earnings
7:38
report. You just picked the biggest engine available.
7:41
Just chose a different vehicle, yeah. So looking
7:44
at those numbers, why wouldn't I just hold 100
7:47
% equities. Like, give me the 387 grand. Well,
7:50
because those numbers only describe the destination.
7:53
Yeah. They tell you absolutely nothing about
7:55
the journey. The roller coaster. The roller coaster,
7:57
exactly. The all equity portfolio will experience
8:00
severe, sometimes terrifying declines that the
8:03
balanced portfolio simply won't. If you were
8:06
entirely in stocks, and the market drops 35 %
8:10
in a month, like we saw early in the pandemic,
8:13
or grinds downward for two years, like the dot
8:15
-com bust, you have to actually live through
8:18
that. Yeah, that's the hard part. Right, because
8:20
if you wake up, log into your account, see your
8:22
life savings cut in half, and you panic sell
8:24
because you can't sleep at night. Then you permanently
8:27
lock in those losses. Yes, you permanently lock
8:29
them in. Which means you never actually see that
8:32
$387 ,000. It's a complete illusion if you don't
8:36
have the stomach for it. The optimal allocation
8:39
on a spreadsheet is actually the completely wrong
8:42
allocation in real life if it causes you to abandon
8:45
your plan halfway through. That higher expected
8:47
return in equities is literally your compensation
8:50
for surviving the volatility. It is the market
8:53
paying you to take on the anxiety. Wow, that's
8:56
a great way to put it. And if you cannot survive
8:58
the anxiety mathematically or psychologically,
9:01
you have no business holding that portfolio.
9:03
So we need an allocation we can actually survive.
9:07
How do we choose it? I mean, people always look
9:09
for shortcuts, and the financial industry loves
9:11
providing them. Oh, they do. Let's look at how
9:14
we set that target. First off, I think we need
9:16
to draw a hard line between strategic allocation
9:20
and tactical allocation. Yeah, this is a vital
9:23
distinction. Strategic allocation is your permanent
9:26
long -term target. You set it based on your life
9:29
objectives, your time horizon, and your actual
9:32
capacity to absorb risk. It has your baseline
9:35
blueprint. OK, so what is tactical? Tactical
9:38
allocation is when you deliberately deviate from
9:40
that blueprint based on what you think the market
9:43
is going to do in the near term. Like trying
9:44
to time things. Exactly. It's moving to cash
9:47
because you read a scary headline about interest
9:49
rates. Or overweighting the tech sector because
9:51
artificial intelligence is having a massive quarter.
9:54
Trying to be clever and outsmart the broader
9:56
market. Right. And the fundamental problem with
9:59
tactical allocation is that it requires you to
10:01
be right about market timing. And as decades
10:03
of research show us, timing the market consistently
10:06
is virtually impossible. You have to be right
10:09
twice. Rez. You have to know exactly when to
10:11
get out of the top and exactly when to get back
10:13
in at the bottom. Most people sell in a panic
10:15
at the bottom and buy back in after the market
10:18
has already recovered, completely destroying
10:20
their wealth in the process. Here's where it
10:22
gets really interesting to me. Because people
10:25
know they shouldn't try to time the market, they
10:27
lean heavily on generic rules of thumb to set
10:31
their strategic baseline. Oh, the rules of thumb.
10:33
Yeah, the most famous one is 100 minus your age.
10:37
So if you're 40, you hold 60 % in equities. If
10:40
you're 70, you hold 30%. Now, wait, I'm going
10:43
to push back here. Doesn't that rule exist for
10:45
a very valid reason? I mean, it automatically
10:48
reduces your sequence of returns risk as you
10:50
get older. If I'm retiring next year, I probably
10:53
shouldn't be. 90 % in stocks. Are we just throwing
10:56
the baby out with the bathwater by calling this
10:59
rule flawed? That is a very fair pushback. I
11:02
mean, the intention behind the rule is sound.
11:04
As your time horizon shrinks, your ability to
11:07
recover from a market crash shrinks with it.
11:09
So yes, broadly speaking, risk capacity declines
11:12
with age. Okay, so why is it flawed? Because
11:16
as a final answer for your portfolio, the heuristic
11:19
is dangerously inadequate. It relies entirely
11:22
on a single variable. It assumes every 60 -year
11:25
-old on the planet has the exact same financial
11:27
reality. Oh, I see. Let's look at a concrete
11:30
example from the research to show why this breaks
11:32
down. We call it the tale of two 60 -year -olds.
11:35
Okay, lay it out. Show me why the math fails
11:36
them. Imagine two individuals, both exactly 60
11:40
years old. Person A has a secure, fully indexed,
11:44
defined benefit pension from their government
11:46
job. That pension will comfortably cover all
11:48
their basic living expenses, housing, food, utilities,
11:52
for the rest of their life. Must be nice. Right.
11:55
Now, person B has absolutely no pension. They
11:57
have been a freelance contractor their whole
11:59
life, and they will rely entirely on their investment
12:02
portfolio to survive. According to the 100 minus
12:05
age rule, they should both hold exactly 40 %
12:08
in equities. But their realities couldn't be
12:11
more different. Utterly different. Let's contextualize
12:14
Person A's pension. A defined benefit pension
12:17
that pays you $50 ,000 a year guaranteed is mathematically
12:22
equivalent to holding a $1 million bond yielding
12:24
5%. Whoa. Yeah. Person A essentially already
12:29
holds a massive invisible bond in their overall
12:31
life portfolio. Their daily survival is completely
12:35
insulated from market fluctuations. So because
12:38
their fixed -intem needs are already met by the
12:40
pension, their actual investment account can
12:42
afford to be almost entirely equities. Exactly.
12:45
Because they have an enormous capacity for risk.
12:48
The worst -case scenario is their portfolio drops,
12:50
but they still eat and pay their mortgage. But
12:52
Person B... Person B has a very low risk capacity.
12:55
Yes. If the market crashes... 30 % the day they
13:00
retire, and they are forced to sell stocks at
13:02
rock bottom prices just to buy groceries. They
13:05
are locking in massive losses and risking running
13:08
out of money before they die. That's terrifying.
13:10
It is. Their correct allocation is completely
13:13
opposite to Person A's, even though they share
13:16
the exact same birthday. Age is a factor, sure,
13:19
but your holistic financial context is what actually
13:23
dictates the math. So relying on the age rule
13:26
is like going to buy a tailored suit. and you
13:28
tell the tailor your height, but you vehemently
13:30
refuse to tell them your weight, it is guaranteed
13:34
to be a terrible fit because you were ignoring
13:36
half of your physical reality. That is exactly
13:39
the mechanism at play. OK, so let's assume you've
13:41
done the deep work. You've ignored the lazy shortcuts.
13:43
You looked at your whole financial picture, including
13:45
any invisible bonds, and you perfectly tailored
13:48
your strategic allocation. Let's say you landed
13:51
on 60 % stocks, 40 % bonds. You aren't done,
13:55
are you? No, you're not. Because the market doesn't
13:57
sit still. This is the silent, creeping risk
14:00
of portfolio drift. Markets are dynamic. If you
14:04
start at a 60 -40 split and you experience a
14:07
massive multi -year bull run in the stock market,
14:10
like we saw for much of the 2010s, your equities
14:13
are going to compound and grow much faster than
14:16
your fixed income. So if my portfolio silently
14:19
becomes a high -speed sports car on its own during
14:22
a bull market, I have to actively hit the brakes.
14:24
I have to interfere with it to stay safe. You
14:26
do. Because suddenly, without making a single
14:28
trade, my 60 -40 portfolio has drifted to, say,
14:32
75 % equities and 25 % bonds. My risk exposure
14:36
has just increased dramatically. And the most
14:39
dangerous part of portfolio drift is that this
14:41
silent increase in risk happens right when you
14:44
feel the most invincible. Oh, for sure. Everything
14:46
has been going up. feel like a genius, your statements
14:48
look fantastic, but if the macroeconomic environment
14:51
shifts and the market suddenly corrects, you
14:54
are taking the hit on a highly volatile 75 %
14:57
equity portfolio. You are absorbing a blow you
15:00
never explicitly planned for and might not have
15:03
the stomach to handle. Which forces us to rebalance.
15:06
We have to bring the portfolio back to its original
15:09
targeted weight. But I really want to talk about
15:12
the behavioral friction here because rebalancing
15:15
sounds like basic maintenance But psychologically
15:19
it is brutal. What's fascinating here is that
15:21
rebalancing goes entirely against human nature.
15:25
Yeah Think about what the mechanics of rebalancing
15:28
actually demand of you. To get that 75 % equity
15:32
allocation back down to 60, you have to actively
15:34
sell your winners the tech stocks or index funds
15:37
that have been skyrocketing and making you money.
15:40
And what do you force to do with that cash? You
15:42
have to use it to buy your losers, the boring
15:45
fixed income assets that have been dragging your
15:47
portfolio down. It just feels so wrong. It does.
15:51
You are systematically buying what is out of
15:53
favor and selling what is hot. Prospect theory
15:56
tells us that humans hate losing things and selling
15:59
a winner feels like giving up future gains. So
16:01
wait, let me stop you right there because beyond
16:03
the emotional pain, my financial panic alarm
16:05
is going off. If I'm selling my winners assets
16:08
that have gone up significantly in value just
16:10
to hit the brakes and rebalance my portfolio,
16:13
doesn't that mean I am generating taxable capital
16:15
gains? Am I literally going to penalized by the
16:18
government just for trying to maintain a safe
16:21
driving speed? That is a highly sophisticated,
16:24
very valid concern. If you execute this poorly,
16:28
the tax drag from rebalancing will eat your returns
16:32
alive. Yikes! And it leads us directly into the
16:35
strategic mechanics of how we rebalance. Because
16:37
maintaining your asset allocation isn't just
16:40
a spreadsheet exercise. It is heavily dependent
16:42
on asset location. Where you hold your money
16:45
dictates how you maneuver. OK, so how do we outsmart
16:48
the tax man here? Walk me through the mechanics.
16:51
The golden rule is you must do your heavy lifting
16:53
inside your tax sheltered accounts. Explain the
16:56
mechanism of a sheltered account for those who
16:58
might just view all their brokered accounts as
16:59
the exact same thing. So depending on where you
17:01
live, governments offer specific investment accounts
17:04
designed to encourage retirement savings. These
17:06
accounts act as a protective bubble. OK, a bubble.
17:08
Yeah. When you buy, sell or trade assets inside
17:11
that bubble, No taxable event is triggered. The
17:14
government doesn't care what you do in there
17:16
as long as the money stays inside the bubble.
17:18
So if you need to sell highly appreciated stock
17:20
to buy bonds, you do it inside the sheltered
17:23
account. You trigger absolutely zero capital
17:25
gains tax. But if I do that exact same rebalancing
17:28
trade in a standard, everyday brokerage account?
17:31
The protective bubble is gone. You realize the
17:33
capital gain, you have to report it on your tax
17:35
return, and you lose a percentage of your wealth
17:37
to the government. You are actively paying a
17:40
penalty to reduce your risk. That is brutal.
17:44
OK, so we prioritize the sheltered accounts,
17:46
but let's look at another scenario. What if my
17:49
sheltered accounts aren't big enough to fix the
17:51
imbalance? Or what if I just have a massive standard
17:54
brokerage account that I'm terrified to touch
17:56
because of the taxes? Well, if we connect this
17:58
to the bigger picture of your ongoing financial
18:00
life, there is an incredibly elegant way to rebalance
18:04
that sidestep selling entirely. I am waiting.
18:07
You use your cash flow. You use your new contributions.
18:10
Yeah, if you were in the accumulation phase of
18:12
your life, meaning you are still working, saving,
18:15
and adding money to your portfolio regularly,
18:18
you simply direct that new incoming cash to buy
18:21
whichever asset class is currently underweight.
18:23
Oh, that makes perfect sense. If my equities
18:26
have ballooned to 75%, I just stop buying equities.
18:30
I take my new savings from my paycheck this month
18:32
and I only buy bonds. I keep funneling cash into
18:35
the shock absorbers until the ratio balances
18:37
back out to 60 -40. Precisely. You are rebalancing
18:40
by adding rather than subtracting. The mechanics
18:44
of this are beautiful. First, you completely
18:46
avoid the need to sell anything, dodging the
18:48
capital gains tax entirely and saving on transaction
18:51
fees. Which is huge. Second, you remove the emotional
18:54
sting of having to kill your darlings and sell
18:56
your winners. Yeah. And third, it forces you
18:59
to naturally buy the asset class that is relatively
19:02
cheaper at that exact moment. You are continuously
19:05
buying low. So we have the mechanism for how
19:07
to do it without getting taxed. But when do we
19:09
pull the trigger? Like, do I need to be checking
19:11
my spreadsheet every Tuesday? Not at all. There
19:14
are two main systematic approaches here. You
19:16
can use a calendar -based approach, meaning you
19:19
ignore the noise and rebalance on the exact same
19:21
date every single year, regardless of what the
19:24
market is doing. OK. Or you can use a threshold
19:27
-based approach, meaning you only rebalance when
19:30
your allocation drifts by a specific percentage
19:32
band. Say if your target is 60%, you only take
19:36
action if it drifts above 65 % or below 55%.
19:39
Is the math heavily weighted toward one being
19:42
better than the other? The empirical research
19:44
actually doesn't declare a definitive universal
19:47
winner between the two. Oh, really? Yeah, the
19:49
critical takeaway from the data is that having
19:52
a mechanical preset rule is vastly superior to
19:55
doing it by feel. If you rely on your gut, your
19:58
gut will always tell you to let the winners run
20:00
indefinitely right up until the moment the market
20:02
collapses. So what does this all mean? Let's
20:05
bring this entirely back to you listening to
20:07
this right now. We've learned that your equity
20:10
to fixed income split isn't just a line item
20:12
on a PDF statement. It is the engine and the
20:15
shock absorbers of your entire financial life.
20:18
It really is. And the Brinson study proves that
20:20
this split drives the roller coaster variation
20:23
in your returns way more than any single stock
20:26
pick ever will. You have to set a strategic target
20:29
based on your actual life circumstances and your
20:32
true risk capacity, ditching those lazy shortcuts
20:35
that ignore whether you have a pension or not.
20:37
Exactly. You need to resist the urge to tactically
20:40
time the market because you cannot predict the
20:42
future. And you have to maintain that balance
20:44
by rebalancing smartly using the protective mobile
20:47
of tax -sheltered accounts or your new cash contributions
20:50
so you don't punish yourself with a brutal tax
20:52
bill. That is a very comprehensive look at the
20:55
mechanics of the portfolio. But I want to leave
20:58
you with one final mind -expanding concept that
21:01
connects right back to your true risk capacity.
21:03
Let's hear it. If you think your investment portfolio
21:05
is your entire financial picture, you need to
21:08
look much closer. We talked about invisible bonds,
21:10
but let's talk about human capital. Human capital.
21:12
OK. Your job, your future income, and your industry
21:16
are massive invisible assets in your life's portfolio.
21:20
Think about the underlying mechanics. If you
21:23
work in the technology sector and your stock
21:25
portfolio is heavily weighted in technology index
21:28
funds or company stock, your true asset allocation
21:31
is wildly more concentrated than your brokerage
21:33
statement suggests. Oh, man. Right. If a macroeconomic
21:37
shock hits the tech industry, your portfolio
21:39
crashes at the exact same moment your company
21:42
announces layoffs. Wow. So where employment risk
21:45
and your investment risk materialize on the exact
21:47
same day, you have zero shock absorbers in your
21:49
actual life. This raises an important question.
21:51
Are you as diversified in your actual life as
21:53
you are on paper? If your human capital and your
21:56
financial capital are deeply correlated, your
21:58
risk capacity is actually much lower than you
22:00
think. That is a phenomenal question to end on.
22:03
Are your invisible assets driving your car off
22:06
the exact same cliff as your visible ones? Mull
22:09
that over. Look at the mechanics of where your
22:11
paycheck comes from and look at what's under
22:13
the hood of your portfolio and ask yourself if
22:15
they are dangerously entangled. Thank you for
22:17
joining us as we strip down the engine of your
22:19
wealth. Keep your hands on the steering wheel.
22:21
Remember your shock absorbers and we'll see you
22:23
on the next deep dive.