Managing risk in a portfolio is not an easy task but with exchange traded funds (ETFs) it can become a lot easier! Here is a simple method I use for managing risk in my portfolios.
Everything in the same basket
First I consider every portfolios as a whole. Let’s say I have one portfolio of 100% equity ETF in my RRSP and 100% fixed income in my TFSA, I will consider both in the same basket. If I have 20000$ in the RRSP and 10000$ in the TFSA, I then have 33.3% fixed income and 66.6% equity. In other words, your risk is calculated as a whole, even if your diversification strategy is divided between multiple accounts.
Different types of investments
Stocks are generally more volatile but will provide more growth to your portfolio. They are parts of a business traded on an exchange and driven mainly by supply and demande. They should be in your portfolio. Still, if you want to minimize risk, you need to diversify your types of investments. For example, if the stock market crashes and you have a portfolio 50%/50% Canadian and US equity (stocks). Then both go down at the same time. That means there is a great correlation between the two. Both markets are sort of linked, most probably because of the high level of import/export going on between the two countries.
Let’s say I start with this portfolio with 100% Canadian all cap TSE:VCN.
I might like the canadian market a lot but I wouldn’t like my finance to be so linked to it! I want to reduce the risk of this going down or stagnating by adding a little touch of something else in there!
REIT ETFs invest in companies that rent commercial, residential and the like. They need to provide more dividend as part of their objective. They can be part of your choice to diversify as well as fixed income, other country equity, emerging markets and so on. For our example I decided to add a small percentage of REIT because I am looking for growth and don’t mind more risk according to a longer term objective of 15 years.
If you look at Google Finance and the curves of both ETFs TSE:VCN and iShares Real Estate Investment Trusts (TSE:XRE). You can see that they don’t seem too correlated, that means that our risk of losing everything in one strike goes down. The risk of a stagnating market goes down as well because we now have two different types of investments. One in real estate and the other in the Canadian stock market.
Here is now what our portfolio looks like!
That’s a bit better, but you might want to diversify more, depending on what your objective is. If you want long term growth, you might want to go more equity, if you think you’re going to need money on the short term (5 years and less), you may want to go with less volatile investments.
Let’s Add Some Fixed Income
Fixed income will (generally) give you more stability and be less volatile. Depending on what type of fixed income you put in you portfolio, it may provide benefits. I will add some TSE:VBU which is Vanguard U.S. Aggregate bonds in my portfolio to make it less volatile and reduce the risk of losing more money in the Canadian market.
As you can see, there seem to be no correlation between TSE:VBU and the two others. But TSE:VBU has been providing less growth. Here is my new portfolio.
Why adding some U.S. to our portfolio won’t reduce the risk as much? The U.S. market tends to be stronger than the Canadian stock market, still they sort of move in tandem like I said above. I need to remember that if I want to acquire some for the portfolio.
In my opinion four different kinds of investments make it easier to rebalance but it’s your choice if you want to add more! Again, it depends on your situation and objectives. Remember that this is just an example and I have not study anything to create that portfolio. I just want to show you what it might look like once completed. In fact, a bit of international equity would be useful to diversify more, I could put some TSE:XEF in there if I wanted!
To Keep in Mind
Managing risk depends on a lot of factors like your objective, the amount of funds you have invested, your interests and so on. My strategy is to diversify the sources of investments towards my goal. For example, if I need 6% return over 10 years, I will most probably put more equity than fixed income because fixed income tend to go slower and is often better on the short term. It is to remember that the past does not necessarily reflect the future in investments. Something that has done well in the pas might not do so well in the future! I do not try to time the market, I just try to always be in the market instead.
Stagnation can be as risky as losing everything in one blow, that’s why diversification is useful. Your personality and your investment horizon can play a big role in how you will built your portfolio. Understand the different factors that influence your investment choices like your age and your goals and your preferences. For example, I tend to really like REIT because I see it as more tangible, I don’t mind more risk and I like receiving dividends once per month. Still, your kind of investment will probably not be the same as mine.
If you are still not sure, I would recommend reading more on the subject or talking to your financial advisor.