Building a Diversified Plan
The key to having a well constructed financial strategy has always been diversification. There was a time where having a mix of different investments was considered sufficient to build a long-term sustainable financial plan. The times have changed and with the massive retirement of the baby boomer generation we have seen our understanding of diversification develop to such an extent that the old asset allocation strategies are only a small part of a well rounded financial plan. Over the last decade, developments have occurred primarily in the areas of asset allocation, product allocation, debt diversification, and temporal diversification.
Though asset allocation is still the cornerstone of a well diversified investment portfolio, with the work of financial strategists like Moshe Milevsky, the definition of asset allocation is expanding. Moshe Milevsky claims that we need to go beyond our current narrow concept where diversification using asset allocation means that we invest in different asset types like stocks and bonds. Stocks are more volatile but they have more potential to rise in value over time. Bonds are less volatile but the do not have the same potential as stocks. A well constructed portfolio will provide the greatest return for a prescribed risk tolerance. The underlying assets are also usually diversified and would not hold all the stocks in one company nor all the bonds with one institution. That way if one company or institution were to run into trouble, it would have a minor effect on the portfolio.
Milevsky suggests that we need to take our own career into consideration when we are considering our asset allocation strategy. Some people lead very volatile lives and have a lot of potential to make a lot of money. Those people are stocks. On the other hand, some people lead very staid lives with very little upside potential. These people are bonds. If your life resembles a stock, you should be invested in bonds. If your life resembles a bond, you should be invested in stocks. This is a simplification of the argument but the underlying message is that we have to think a little more creatively and a little more holistically when we are constructing financial plans for people.
The Expanding World of Asset Allocation
Whereas asset allocation once meant dividing assets among three assets: stocks, bonds and cash. The investment choices available to the general public have expanded dramatically even within the past five years. A well diversified portfolio today will consist of all or many of the following: stocks, bonds, cash, real estate, commodities, absolute return, private equity, private placement, mortgages, private income trusts, and farmland.
A recent article in the Globe and Mail outlined what many of us in and out of the financial industry have known for a long time: Canadians are not adequately prepared to fund their retirements. According to the article, the government is putting together a task force to try to come up with a way to stem this potential retirement income crisis. I was talking with my contact at Manulife recently and mentioned the article to him. He quipped that he didn’t know why the government was going to all this trouble as Manulife has already figured it out. Although he was speaking tongue in cheek, he was at least partially right.
Product allocation takes the focus off how to most effectively accumulate assets and instead focuses on how to most effectively distribute assets and how to distribute those assets so they will last for the full retirement period. Retirement for some people will last up to one third of their entire lives. This is a factor that retirement planning did not historically have to take into account.
Typically, when a person retires, there are four main financial products that will provide them with a retirement income: SWPs (Systematic Withdrawal Plans), Private Income Trusts, SPIAs (Single Premium Immediate Annuities) and more recently GMWBs (Guaranteed Minimum Withdrawal Benefits). All three of these financial products have different advantages and shortcomings. However, the various products are complementary in such a way that a well planned combination allows the retiree to take advantage of the benefits while minimizing the shortcomings. This is diversifying investments across product types.
Actually diversification is not desirable when it comes to debt. It is much better by far to consolidate debt. So what does it mean to consolidate our debt? The first step is to move all debt to the loan with the lowest interest rate and best terms. This is usually debt backed by real estate like a mortgage. We call this spatial consolidation as we are “moving” the debt to one “place”. However, there is another type of debt consolidation that is just as powerful: temporal consolidation.
We typically diversify our debt temporally. For example, we might get paid on the first of the month, pay our mortgage payment on the tenth and then use the leftover money at the end of the month from our bank account to pay down our line of credit. Our debt payments have been spread or diversified across the entire month. This is a very inefficient use of our money as our debt is allowed to accrue interest. We can consolidate our debt temporally by ensuring that all income is used to pay debt immediately.
If you want to find out how much interest you might save by consolidating your debt both spatially and temporally, try Manulife Bank’s calculator. You could win $500 just for trying it out.
A recent study conducted by Ian Ayres, Barry J. Nalebuff of Yale University might be of no surprise to any of us. It found that people generally did the bulk of their saving at the end of their work lives. This is what we would consider a temporal consolidation, that is, people tend to consolidate their investment period to the time directly before they retire. We know that when it comes to investing diversification allows us to enjoy a greater return for less risk. Consolidating our investment period does the opposite. It increases our risk and provides a smaller return. Ayers and Nalebuff concluded that diversifying our investment period across the entire span of our working life would allow us much greater returns at a reduced risk. The most effective way to spread our investments over our work lives is to leverage our investments. In Canada we have the added bonus that structured properly, the interest portion of our leveraging payments are tax deductible.