(This article discusses financial issues and uses fictitious names of people for illustrative purposes.)

It’s the weekend and Steve and Rhonda Baker are sitting down to a late breakfast with their son, Adam. Last month, the Bakers were preoccupied with tax season.

They shared how, with the help of their money manager, they use a strategy called “asset allocation” to reduce their tax bill. This morning, Adam is sipping on his coffee, with sleepy eyes after spending the last few nights studying for finals. Adam has quite a few years of studies left before he leaves home and as such, Steve and Rhonda are heading into retirement while supporting him in his last years of school. Steve sits at the table and begins looking over the previous day’s mail when he comes across their financial statement. He opens it, looks it over and with a satisfied look, sets it aside.

“Can I see that?” Adam asks. Steve is somewhat surprised since Adam has never shown interest in their holdings before.

“Sure,” he responds, “why so interested all of a sudden?”

“In my economics class, we have been discussing asset allocation.” Adam replies. “I just wanted to see if I could understand how your assets have been allocated.” Asset allocation is a strategy which distributes an investment portfolio among different asset categories based on an investor’s ability to trade off risk and returns. The basis of this theory is simply not to put all your eggs in one basket. The general idea of asset allocation is to minimize the risk or volatility of your portfolio for a targeted rate of return. In essence the focus is not on the return of an individual asset, but on the return of your entire portfolio. Assets should be chosen that will work together to reduce the volatility of your portfolio, while maintaining the target return. The appropriate portfolio for someone depends on the targeted rate of return as well as risk tolerance. Risk tolerance of course depends on many things including the number of years that the investment will be held. “You do realize that as you approach retirement, you should be adjusting your portfolio to reflect a reduced tolerance for risk, don’t you?” continues Adam. Steve looks impressed.

“No need to worry about that;” Steve answers, “our money manager has advised us about asset allocation. She has everything under control.”
Steve and Rhonda have been investing for retirement since they were only a few years older than Adam. Since they are now just a few years away from retirement, they don’t want to put their nest egg in the path of any undue risks. With the help of their money manager, they recently adjusted their portfolio in consideration of this. Their portfolio is divided among the three major asset categories: stocks, bonds and cash. This is to say that when one category is not performing well, the others may be gaining nicely. By holding some of each, the Bakers are able to counteract the losses of one category of assets with the gains in another category.

“My professor used the story of the street vendor who diversified his line of merchandise by selling both umbrellas and sunglasses. To ensure that no matter what the weather, he will decrease his risk of losing profits so he sells both.” Adam states, “That way, when it’s sunny, although the umbrellas won’t sell, the sunglasses will and vice versa.”

“That’s right,” says Steve, “market cycles that may cause one asset category to have poor returns may have the opposite effect on another asset category. By holding assets in all these categories, you reduce your risk, just like the vendor.”

“So how does your portfolio take into account the fact that you will be retiring soon?” asks Adam.

Rhonda pours herself some orange juice and sits down. “Well,” she says, “our holdings are divided into stocks, which have the greatest potential for growth, but also the highest level of risk, bonds and preferred shares which are less volatile, but bring more moderate returns and cash and cash equivalents which are low risk, but also bring the lowest returns of the three categories. Our money manager helps us to balance these categories by taking into account our level of risk tolerance, our income needs in retirement and our time horizon.” Adam looks puzzled. “The amount of time we will hold the investment before we will use it,” Rhonda explains.

“Asset allocation is an extremely important part of investing. When you are ready to start investing, the best thing that you could do is seek the help of a professional.” Steve advises, “Without our money manager to guide us, who knows where we would be.”

“There is more to asset allocation than just diversifying your portfolio and then waiting for your investments to grow. There is also rebalancing to consider.” Rhonda says. “But, we have to go; we’re late for our tennis lesson now, so we’ll have to talk about that another time.”

Adena Franz is a Vice President and Portfolio Manager at MacDougall MacDougall & MacTier Inc. She can be reached at 514-394-3771. The information contained in this article is for general information purposes only. It does not account for specific investment objectives or the financial situation of any person reading it. Opinions expressed are those of the author and do not necessarily represent the opinions of MacDougall, MacDougall & MacTier Inc. Investors should seek professional advice regarding the appropriateness of investing in any securities discussed or recommended here and should recognize that statements regarding future prospects may not be realized.

MacDougall, MacDougall & MacTier Inc.
The Franz Group
1010 de la Gauchetiere Ouest, Suite 2000
Montreal, Quebec H3B 4J1

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