The Asset Allocation Decision

In simplest form, the asset allocation decision is the proportion of stocks relative to bonds that you decide to hold in your long-term investment portfolio. You may be asking yourself, why should I invest in either of these?

The short answer is inflation and how this impacts our cost of living over time. The Bank of Canada has a public calculator that projects how much a product/service will cost Canadians in 2025 if it cost $X amount in a previous year. To help paint this picture, I mapped out how much a product/service purchased in 1970 for $1 would cost today. The results were shocking – the same product/service would cost ~$8.10 today, which represents a ~710% increase!

Needless to say, we as investors need to take action to ensure that our wealth grows at a pace that matches inflation, if not outpaces it, to be able maintain our standard of living over time.

We take a very evidence-based approach to wealth management and there is a wide body of research that suggests that a fantastic way to combat inflation is to invest our long-term money in stocks and bonds. Our colleague Ray recently published an excellent blog that outlines what level of pre-inflation returns Canadian investors realized between 1970-2024 if they invested in a variety of asset allocation strategies.

If you review the table below, you will see that by 2024, a Canadian investor who held a 100% bond portfolio (Canadian total bond market index) had $48.65 in their portfolio if they invested $1 in 1970, while a 100% stock investor (globally diversified) had $130.44 in 2024. So, if global stocks generated the greatest amount of wealth for investors, why should you consider owning any bonds?

Source: PWL Capital, Data Source: DFA

Well, investing in stocks and bonds both come with risk, albeit different kinds of risk. Stocks are risky because stock prices can fluctuate quite dramatically in the short term, while bonds are risky because they are sensitive to changes in interest rates and have lower expected returns relative to stocks, which can make it more challenging to keep up with inflation over time.

If I reflect on some of the worst drawdowns that stock & bond markets have experienced in recent history, I’m drawn to the Financial Crisis in 2008-2009. If you were invested in 100% stocks, your portfolio declined in value temporarily by 48%. If you were invested in a portfolio that consisted of 40% stocks & 60% bonds, you experienced a temporary decline of 19% during that same period. In essence, including more stock exposure in your portfolio increases the ceiling for long-term wealth you can accumulate, while including more bonds can decrease how severe of a market correction your portfolio can experience.

Now that you are up to speed on why it makes sense to invest in stocks and bonds, I’ll outline how we help our clients determine what their ‘optimal’ asset allocation strategy can look like. I’ll preface by saying that we never tell clients how much risk to take with their investments, as risk is a very personal feeling, but we’ll do our best to outline relevant considerations and how different strategies impact their long-term financial plan.

Step 1 – Understand Your Risk Tolerance & Capacity

Our team starts this process by sending investors a risk questionnaire, which helps us learn more about their personal feelings towards risk and investing. I find this to be a helpful exercise as we get to learn more about how investors feel about the risk/reward tradeoff and how they would react when we simulate various market corrections. My favorite part about this step is comparing the results of two spouses when we are working with a family, as it is rare that the results match and this offers a natural segue to learn more about their experiences growing up with money. Once we’ve reviewed their risk questionnaire results, our team works on identifying what an investor’s capacity to take on risk looks like. This typically involves understanding what your time horizon for investing could look like, whether you’ve established an emergency fund, acquired sufficient insurance and analyzed cash flow stability to be more certain that investors can afford to take on investment risk.

Once risk tolerance and capacity are considered, our team has access to software that will grade risk questionnaires relative to others who have gone through a similar process and suggest a range of stock/bond exposure for that investor to consider.

Our team doesn’t stop here when helping clients determine asset allocation, but this initial step ensures that we’ve done our due diligence before moving on to the next stage, which I’ll outline next.

Step 2 – Build a Financial Plan

Now that we’ve identified a potential range of stock/bond exposure, our team will then build a financial plan to understand how the asset allocation decision impacts our clients in the context of their long-term financial planning outcomes. We typically find that families who are approaching financial independence or have transitioned to retirement value more certainty over their financial planning outcomes, and a reasonable step to accomplish this is to add more bond exposure to a portfolio. By modelling different asset allocation strategies in a client’s financial plan, we are able to help them understand what expected rate of return they need to achieve/maintain retirement security, which then sets the ‘floor’ for how much stock exposure to include in their portfolio. This has helped tremendously to reframe how our clients think about this decision, as the difference between the expected rate of return needed to fund their financial plan and the strategy that they choose is a reflection of their willingness to take on additional risk to capture the associated expected return.

Since we work on asset allocation planning within an investor’s financial plan, we can also attempt to quantify how different asset allocation strategies influence how much investors can afford to sustainably spend over their lifetime, when they can retire, as well as the financial legacy that they leave behind one day. All of this planning is stress-tested using a Monte Carlo simulation which tests these financial plans against 1,000 different scenarios of good and bad stock/bond returns associated with a particular asset allocation strategy to ensure that the plans work even when markets fluctuate.

Step 3 – The ‘Asset Allocation Email’

We send new clients this email when they are deciding on an asset allocation strategy for the first time with us. We clearly outline the risk/reward characteristics of investing in stock and bond markets, as well as key elements of their financial strategy to keep in mind such as:

• Are they paying down debt? This can be interpreted as a ‘safer’ sleeve of investing to complement a long-term investment portfolio.
• Do they have access to a defined-benefit pension plan (or Canada Pension Plan/Old Age Security) that provides guaranteed income in retirement regardless of what happens in stock and bond markets? This can be interpreted as having ‘extra’ bonds in the portfolio when you think of one’s net worth more holistically.
• Did they decide to create a larger emergency fund (6+ months of after-tax expenses), which may provide confidence to include more stocks in the portfolio?
• How are they invested today and how have they managed to get through previous market fluctuations?
• Are they considering an asset allocation strategy with more stock exposure than we modelled in their financial plan? We’ll support that decision if it makes sense, but it becomes important to note that one may be taking on more stock risk than they need to accomplish their goals.

We include a visual of our model portfolios so clients can see the historical returns that clients realized over various time periods, but also the worst draw down that the portfolio had to endure without making any changes in order to capture that return.

This email will outline reasons to include more stock exposure in the portfolio, such as potentially reaching financial independence sooner than anticipated and/or improving spending/net worth outcomes as well as how more bond exposure provides more certainty in our financial planning activities, which I find many clients appreciate closer to retirement.

At this stage, we are hopeful that we’ve sufficiently equipped our clients with enough information to make an educated decision, and we ensure that they know that we regularly reassess the relevance of their asset allocation strategy as we continue to meet over time

Final Remarks

I firmly believe that an investment strategy is only any good if one can stick to it, especially when markets are noisy, as you likely won’t benefit from the expected return of the portfolio if you don’t endure the risks associated with investing. Navigating personal finances can be stressful, so it is important that investors achieve peace of mind and sleep well at night without worrying about how their portfolio fluctuates in the short term. New investors, especially when they are just getting started, feel the need to invest in stock heavy portfolios to catch up on savings or returns that perhaps they didn’t get to capture before, but I am not a fan of this approach.

Investing is a marathon, not a sprint. Market volatility is never fun and every time a significant market correction takes place, I find that our clients inch towards becoming increasingly more comfortable with the risks of investing, to the point that they are eventually unphased by volatility entirely. I sincerely believe that this is largely because they picked an asset allocation strategy that they could comfortably endure while working towards becoming more confident investors.