Do you have AAAD?

It’s not a bad thing if you do.  It’s actually a great thing.

No, not ADHD (Attention-Deficit Hyperactivity Disorder) or ARDS (Adult Respiratory Distress Syndrome) or AAA (American Automobile Association) – although the latter is a great membership to have.

But AAAD (Asset Allocation and Asset Diversification)?

I think every DIY investor should know about it and strive for it to match their investment objectives. First, my definitions:

Asset Allocation (AA) involves deciding the right mix of asset classes for your investments.

Personally, I think the mix should include some risks for some rewards. For example, the classic asset allocation is 60% equities and 40% fixed-income. If your retirement day is at least 20 years away, like me, you may want to have more than 60% of your holding in equities. I say may because you must be prepared for the risks of having a high-equity asset allocation. Just look at the TSX today (down over 250 points)! Conversely, if you’re within five years or so of your retirement, you might want to stay closer to the “classic” asset allocation recipe or hold ever closer to 50% bonds.

Asset Diversification (AD) involves deciding the right types of investments to hold within each asset class.

In my example above, you might want to allocate your 60% equities to dividend-paying stocks, mutual funds or ETFs. Similarly, you may want to have your 40% fixed-income in government investments certificates (GICs), corporate bonds or bond funds.

Unlike ADHD and ARDS, you want AAAD because it’s one of the tenants of good investing. A quick analogy if you will. Ever seen a street vendor sell different products, say hamburgers, hotdogs, sausages and french fries from his wagon? Mr. Vendor knows without proper allocation and diversification, it’s harder to make a buck; harder to make his margins. By deciding on the right mix of grilled foods and sides Mr. Vendor is offsetting his risk of losing money on any given day. You and me should do the same in our investment portfolios. Mr. Market is just like the customers of Mr. Vendor, not predictable.

For the DIY investor, here are a few takeaways for you and me to remind ourselves about AAAD:

Asset Allocation (AA):

• Your asset allocation is largely personal and it should change over time. I know mine will. It should depend on your investment time horizon and your ability to tolerate risk (i.e., more time = more risk to live with and recover from economic cycles).
• When it comes to investing, always remember risk and reward are intertwined.
• It’s well-known that stocks have historically had a greater risk than bonds and higher returns amongst “the big three” asset classes: stocks, bonds and cash. Investors who hold good, quality, well-known, established blue-chip companies should be able to ride out volatile economic conditions and yield dividends over time. That’s my plan…
• Real estate, gold and commodities are other types of assets, but like most purchases in life, you should be comfortable with what you buy and know why you are buying it.

Asset Diversification (AD):

• If you can’t afford to buy many major stocks in a market, who can really? – consider a low-cost mutual fund or an ETF that tracks the market you want to invest in, say the TSX/S&P 60 Index or TSX Composite Index. Either option hold plenty of companies so that’s immediate diversification.
• Know that different investments, in different classes, will perform differently under different market conditions. Huh? For example, bonds are good to hold, no doubt, but bond prices have an inverse relationship with interest rates. Rates go up, bond prices go down.
• While some mutual funds are great, know these products are designed to offer diversification for a fee and it doesn’t always offer diversification. For example, the fund you are picking might focus on a particular industry sector, say energy, and charge a hefty management expense fee for managing the energy stocks in fund. There could also be fees at “the front-end” or at “the back end” of mutual funds. (I prefer ETFs myself so I don’t have to worry about this.) Again, my message to myself and others is the same: know what you’re buying and why you’re buying it.

As I become more mature at personal finance, AAAD is definitely something I want to get better at.

I know if I improve at it, it will help me reach my long-term financial goals but also to offset risk and keep the pillow soft at night. If the TSX is down 250 points or up, it won’t matter – I’ll have AAAD.

I’m getting closer to having AAAD, are you?

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