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We started our mailbag segment last week and are hopeful it will continue to pay dividends (and capital gains for that matter). Today we’ll take a look at a follow up question from the same reader (Rachel) as last week:
I am finding myself a little confused over concepts like ‘asset allocation' and ‘diversification' when it comes to ETFs, and I was wondering if you had any posts or podcasts about that area. Does one need to diversify with ETFs? Doesn't their span of content take care of that for you? I also find asset allocation tricky to wrap my head around because our assets are spread so thinly when we use them. If our assets are tied up in stocks, sure we want to allocate them well, but do we worry about asset allocation as much with ETFs?
And lastly, are there ETFs for the asset class of ‘Cash & Equivalents'? I assume yes, but if we passive investors are doing a hands off, long-term thing, are C & E's even worth going for? They seem like a really unappealing group to me.
It's best to think of asset allocation as the big picture and diversification with each asset class as the smaller details. If you think of your entire investing portfolio as a pie chart (original I know) asset allocation is how big a slice each type of asset will take up. Some of the pie will be Canadian stocks, some will be USA stocks, maybe a slice will be international stocks, and a slice will be bonds or other low-risk investments. How big each of these slices are is basically the concept of asset allocation. Most people would say that as you get older you should have a bigger and bigger slice (or part of your portfolio) in less-risky assets such as bonds.
Also, while I’m not a proponent of these asset classes, I should mention that some people would recommend gold & precious metals, real estate, commodities, and few other types of asset classes that could have a spot in your portfolio. If you’re just starting out though I would try to keep things as simple as possible and ignore those asset classes until you’ve done some research and feel comfortable with them.
Within each of those asset classes, it is best to own a wide variety of companies (stocks) or bonds. Investing people will call this “exposure”. For example, if I want 25% of my portfolio to be Canadian stocks, I can’t just buy a bunch of RBC shares and say “there done, now I have exposure to Canadian equities”. Instead I'd buy units of a TSX 60 index (the most popular one is XIU), where my money would get spread across the 60 largest companies in Canada. Then I might buy an S&P 500 index for USA stocks etc. You could also purchase several shares of many companies in the TSX 60, and that would also be considered to be diversifying your portfolio and getting broad exposure, that’s just a lot more complicated and you should know a lot more about how to evaluate companies before venturing down that path. It is also much easier for trading fees to kill your profits if you’re a small-scale investor investing through individual stocks and bonds.
Just because you don't have a ton of investable assets now, that's perfectly ok, the same principles can still be applied. You might want to think about a portfolio with $1,000 in it, with say $300 in Canadian stocks, $300 in American stocks, $300 in international stocks, and $100 in bonds (which I'll get to in a second).
I don't think having a sizable part of your net worth in cash is a good thing – especially if you're saving for retirement and you’re thirty-years-old. The reason is that cash is by definition a losing investment due to inflation (if you keep wealth in cash it goes down in value 1-3% every year). Instead, if you want a part of your portfolio in low risk investments I think bond ETFs are worth looking at. I can’t recommend specific securities for specific situations, but the bond ETF I use has the ticker symbol XBB. Basically, it's like having a bunch of different Canadian bonds rolled into one and then you get the average return. It's sort of like investing in a bunch of different Canada savings bonds and provincial savings bonds – very safe, but a fairly low return.
I’ve written an article that talks about my seven favorite ETFs for Canadians that will give a more in-depth explanation as to why I like them. I have also recorded podcasts about why young people don’t need to be afraid of stocks, and how to invest like a couch potato. Hope this helps!
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