Financial Planning Newsletter

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1 Financial Planning Newsletter Structuring Your Portfolio for Future Success? Beware of Misleading, Misinterpreted & Out Dated Information Wealth Management Steinberg High Yield Fund Steinberg Equity Fund subscribe to our newsletter Montreal: (514) Toronto: (416) This article focuses on positioning portfolios with regards to asset allocation decisions and what should be the driver of such decisions. By: Susan Mallin, Certified Financial Planner Contact or Susan Mallin is a Certified Financial Planner and Chartered Investment Manager with over 17 years of experience. She is also knowledgeable in cross border issues for US citizens living in Canada, as well as Estate Planning for Canadians.

2 In last month s financial planning article I wrote about the four factors that are important for the success of a retirement portfolio. If you missed it, you can read it here. The four factors for success were: 1) Asset allocation 2) Quality of security selection 3) Fees 4) Performance Controversy exists in the industry where many investors and analysts still believe that asset allocation is the most important determinant of the success of a retirement portfolio. In fact there are those who go so far as to claim that asset allocation attributes to over 90% of success. This is misleading and stems from a widely misinterpreted study done in More on this later. In Fact, the top determinate for portfolio success is performance; whereas asset allocation is the least important out of the four. Performance doesn t necessarily mean getting double digit returns year over year; rather, it means meeting the pre-stated performance objective of a given portfolio. If a portfolio is not achieving its intended performance, the entire outcome could lead to failure to meet personal objectives. The lack of performance could be attributable to any number of factors, with asset allocation as potentially being only one of many other causes. Asset Allocation Defined Asset allocation is done by spreading money across these five major asset classes: 1) fixed income 2) equities 3) real estate 4) commodities 5) cash equivalents. The idea is that these asset classes are not wholly correlated with each other. Traditionally, when one or two asset classes are underperforming, the others tend to be outperforming. It is a very simple starting point for adding diversification to a portfolio. Allocating money over various asset classes can be employed to reduce volatility in a portfolio. It is a straightforward risk management tool in its most basic form, and from that perspective, it is indeed, very important. Where the 90% Fallacy Comes From The reason why many have heard that asset allocation contributes to over 90% of the performance in a portfolio is based on a study done in 1986 by Brinson, Hood, and Beebower (BHB). In their article titled The Determinants of Portfolio Performance, 91 large pension funds are compared to a selection of indexes (cash, stocks and bonds), in order to mirror the pension asset allocation. The study found that over a ten-year period there was a 96.7% linear correlation and a 93.4% variance of returns between the pension funds and index returns. Are you still with me? Not to worry, you are not alone as this study has been misinterpreted by many. In general terms, the study grouped the relevant indexes, with the goal of mimicking the asset allocation of the pensions over a ten-year period. At the end, they compared the performance. The difference in performance was to determine how much, if any, the pension manager outperformed the passive index benchmarks. In some ways, it really is a study comparing passive investing versus active management using similar asset allocations. This particular study showed the pension funds did in fact outperform. The conclusion has been widely misinterpreted and has led to the mass development of asset allocation funds, balance funds, and index tracking products in the industry; and marketed in such a way to make people think that simple asset allocation is the fool proof way to get good returns. The truth is, however, that it does not mean the overall performance of the portfolio will necessarily be good. What it does mean, is that managers can be measured by how much value they provide over and above the passive indexes leading to benchmark comparison, which will be a topic in a future article.

3 New Studies Over the years, the BHB study has been re-tested by various academics and they now say that asset allocation explains closer to 40% of returns (nowhere near the often misquoted 90%). In fact, what experts seem to agree on now, is that although asset allocation is important from a risk perspective, what is more important and the biggest drivers of performance is what you own and when. Most of the older studies focused on the saving stage of retirement portfolios, or pension funds where there is a constant inflow of money. However, when a retirement portfolio eventually provides an income, it is termed a distribution portfolio, and very few studies have been conducted on the distribution portfolio until recently. A good reference guide is from the Canadian Securities Institute, Advanced Retirement Planning book, which illustrates extensive studies and back-testing analysis on distribution portfolios. It is crucial to achieve a certain rate of return that will support the longevity of the portfolio, based on the projected income withdrawal rate over the years. For example, let s assume a portfolio is withdrawing an increasing level of income over the years and in order to support it, it requires a 6% annualized rate of return. If the portfolio does not achieve that level of performance, the probability of failure to achieve personal goals becomes heightened. In fact, consistent underperformance below the required return leads to problems that may only surface years later, making it extremely difficult to recover. As the portfolio value decreases over time, due to lack of performance combined with income withdrawals, the actual level of withdrawal rate will invariably start to increase quickly (and too soon). Once the withdrawal rate reaches 10%, the portfolio will deplete rapidly. When it comes to the distribution stage, the rules change and there is much less room for error. The Four Year Test When performance issues are not detected early enough, recovery can sometimes become nearly impossible. Simply cutting down on the withdrawal rate may not be enough to fix the problem. Most investment counsel firms will keep track of client performance on an ongoing basis. Rate of return calculations can differ as well, and can become more complex as income starts to flow out of the portfolio. The Chartered Financial Analysts Institute (CFAI) prefers the time weighted rate of return formula. But, like the saying goes, there is more than one way to skin a cat performance calculations can be done in several ways and results can varying widely. There is a simple self-test you can perform once your portfolio is in its fourth year of the distribution stage. If its market value is lower today than it was four years ago, it is an early warning signal that the retirement portfolio is off track. Choosing the Optimal Asset Allocation When it comes to deciding on an asset allocation in a retirement portfolio, we first have to know what rate of return is required to support the future desired withdrawal rate of the portfolio. Through this process, I can then optimize the asset allocation strategy that demonstrates the likelihood it can perform at the required level. To keep it simple, let s assume that the chosen asset allocation is one-year cash requirements, with the balance being 60% fixed income and 40% equity. If asset allocation was all that was needed to make this retirement portfolio a success, then my job would be done. The problem with stopping at the asset allocation level is that there are no guarantees that the above asset classes will provide the required rate of return in the future the same way they did in the past. We can look at historical numbers as a gauge, but driving by looking in the rear-view mirror is never a great idea. The next 20 years of investment returns on various asset classes may look substantially different than the last 20 years.

4 The Best Determinate of Performance is What you own and When The new studies say the best determinate of performance is what you own and when. The what is the type of investment selection in the appropriate amounts, and the when is market timing (the two words that make many experts cringe). If we look at quality of security selection within the fixed income portion, the best products to have owned would have been very long-term government bonds bought over 20 years ago. Today, we might look at long-term government bonds as posing the most risk to loss of capital in the next 20 years. What used to be considered a risk-free return has now become a return-free risk. We might even look at high dividend yielding stocks of mature companies in the same light. Are we at an inflection point? Is this the time to adjust portfolios to reflect a possible new shift in direction for the next 20 years? Let s look at some historical charts. Very long period of increasing rates followed by a dramatic peak and resulting in a long period of declining rates (about 30 years of declining rates). Buy long term bonds here Don t buy Long-term bonds here But Good corporate bonds ok

5 As we can see from the charts, we have been in a very long, yet bumpy, period of declining interest rates since In a period such as this, almost all asset classes perform pretty well, especially the long-term fixed income products. It is possible that the current period of low interest rates and muted inflation will stay low for some time to come. Timing the exact bottom requires a skill in guesswork and can really only be done in hindsight. However, it would be foolish to think that this can go on the same way forever. At some point the trend will change and various asset classes will perform differently than the past. Certain assets will perform fine when the trend changes; and some will not. (Chart source: Trading Economics Canada 10 yr bonds since 1985) The Natural Way of Knowing the When Value-based investing is a natural market timing strategy. It may seem simple, but it extremely difficult. The simplicity is the notion of buying good companies when prices are low, and selling when valuations/prices are high. The difficulty arises in being able to select true value and not to get caught in a value trap, where price recovery never happens. Even more difficult, is the level of patience an investor may need to display if the investment stays out of favour for a longer period than anticipated. Another difficulty is the tendency to allow cognitive biases to get in the way of good decisions. Sometimes low priced assets are perceived as bad investments. The natural assumption is that it was punished for a good reason, or that because it has performed badly it will always perform badly. Of course, the opposite is the bull trap, where overconfidence often leads to the dismissal of new and valid information because it conflicts with the original decision. Good value managers can overcome these challenges through years of experience. You will often see them with high cash positions when markets become expensive, and you will also find them quietly investing when everyone has abandoned the party. Overall, they understand that there is less risk in being too early than in being too late. There are some statistics that show being fully invested at all times does work out in the end. However, studies of behavioral finance and statistics on the flow of money also show that people invest the most at the top of the market and the least at the bottom. Simply put, most people don t emotionally tolerate severe corrections and large numbers have historically cashed out at the bottom in despair. In many cases, however, retirement portfolios simply do not have the time horizon to wait many years for the eventual smoothing of markets. Managers have to understand that there are real people attached to the portfolios that they manage. The markets, in general, have done very well in 2013, with many posting double digit returns, including our Steinberg value equity portfolio (which was up over 20% for the year after fees). With North American markets being driven more by valuations (i.e. multiple expansion) than by fundamentals, finding real value has been much harder to come by and we have been setting our sights on cheaper hunting grounds (like Europe and Japan). At this point, we are holding a large cash position and have a long list of great companies we would like to invest in when the price is right of course. Perhaps, if you are not already, it s time you invest alongside us? Conclusion: The required performance in a portfolio is important in order to achieve the desired objectives and goals. The required performance rate is determined during the financial planning session and it becomes your personal benchmark going forward. Asset allocation is important to manage the overall portfolio volatility and to spread risk. Poor investment selection, even if an asset allocation is employed, can still lead to underperformance of your personal benchmark. Asset allocation should be chosen based on forward return expectations from each asset class mixed in an appropriate ratio. Further diversification is necessary in order to be best positioned to reach your performance goals with the least amount of risk. Value investing is the best natural market timing strategy, and since investments are bought at low prices, it also lessens the downside risk of large capital losses.

6 Good quality security selection within the asset classes, based on the economic environment to come, will be an important factor in achieving the required performance. If you are approaching retirement or are currently in retirement, it is important to monitor the performance of your portfolio against your required return needs. It is a good time to really look at what is inside your portfolio and determine if those assets are positioned to provide the type of performance required going forward for the next 20 years. Written by Susan Mallin, CFP, CIM, Vice President Financial Planning, Associate Portfolio Manager. Steinberg Wealth Management. Contact information susan.mallin@steinbergwealth.com Phone: or Please contact Susan directly at if you have any questions about this article, need financial planning or for further information about Steinberg Wealth Management Susan Mallin is a Certified Financial Planner and Chartered Investment Manager with over 17 years of experience. She is also knowledgeable in cross border issues for US citizens living in Canada, as well as Estate Planning for Canadians This document is prepared for general circulation to clients of Lorne Steinberg Wealth Management (LSWM) and is provided for information purposes only. It is not intended to convey investment, legal, tax or individually tailored investment advice. All data, facts and opinions presented in this document are based on sources believed to be reliable but is not guaranteed to be accurate, nor is it a complete statement or summary of the securities, markets or developments referred to in the report. This is not a solicitation for business. Past performance is not a guide to future performance. Future returns are not guaranteed. No use of the LSWM name or any information contained in this report may be copied or redistributed without the prior written approval of LSWM. Creating Value.