Asset allocation is the percentage an investor has in cash, fixed income, and equities. Many finance books talk about the percentage that you choose to have in each of these categories as being the single biggest determinant on overall investment returns. In addition, the asset allocation is designed to be customized and structured based on your investment objectives and risk tolerance.
A balanced portfolio may include 40 per cent in cash and fixed income, with the remaining 60 per cent in equities. A moderate growth portfolio may have cash and fixed income at 20 per cent, and equities at 80 per cent. Equities are typically the largest component of most people’s portfolio; therefore, it is the focus of this week’s article.
Just as important as the percentage that you have in equities is the type of equities that you have.
When we talk to clients about the equity component, the discussion always centers on getting the best quality companies. This was outlined in our article outlining our 10 principles for picking stocks. Investing in equities is also about avoiding mistakes as much as you can. The following is a list of the 10 most common equity investing mistakes we have seen.
1) Speculation
In recent years the term “fake news” is hitting the limelight primarily as it relates to politics, medical news, and other hot topics. Within the investment world, it has existed in all the years that I have been interested in finance (over 30 years).
“Boiler room” was a term used in finance for unscrupulous call centres that would use high-pressure salespeople to make cold calls to sell speculative securities. The term “pump and dump” was used when the securities marketed were fraudulent. Even with the National Do Not Call list, new methods of marketing through social media can result in people believing what they read, and getting scammed out of their money.
2) Herd mentality
Herd mentality is when investor’s behaviour and beliefs conform to those other investors that they know. For example, an investor you know may have speculated on some small capitalized company, cryptocurrency or cannabis securities.
Most speculators are happy to talk about the winners and are relatively silent on the losers. Hearing a friend, neighbour, family member or colleague talk about an investment plants the seed, or thought that I must get exposure to that fast growing area. It is the next big opportunity.
The fear of missing out further on what other investors have already participated in results in people making quick decisions that are not based on solid fundamentals. There is a reason why mutual funds must disclose that past performance is no indication of future performance.
3) Position concentration
In order to get an adequate level of diversification we recommend our clients have anywhere from 25 to 35 holdings, depending on the asset allocation. In no situation do we recommend investing any more than five per cent of your portfolio in any one company. If clients choose to hold an excess amount in one company, we have them sign an Investment Policy Statement that specifically states that they understand the risk they are assuming. There are simply too many good companies out there to not hold a minimum of 25, in my opinion.
Despite this, we have met with people who had put all their money in one company and others who only bought a few companies. We have also seen people who have failed to rebalance their holdings as it increased in value only to see it subsequently decline with no realized profit.
4) Sector concentration
One of the reasons to have sector diversification is to reduce portfolio volatility. We feel that managing sector exposure is a critical component of managing overall equity risk. For example, sectors such as energy and materials are naturally higher risk than investing in utilities and consumer staples.
All too often we see investors who have a significantly overweight exposure to a sector. This concentration risk can come at an extreme cost if that sector were to come out of favour. As an example, an investor who over-weighted the energy sector at the beginning of this year would have seen a material pull back in March, with some names declining as much as 90 per cent.
5) Geographic concentration
With each passing year that I have been a portfolio manager, I have found that I have made more global purchases of securities and not just focused on Canadian investments. The majority of the best companies in the world are located outside of ÎÚÑ»´«Ã½.
Often when I review a portfolio that has transferred to us all in-kind, we find that the positions held will be 100 per cent in Canadian centric. I’ve heard Canadians say that they didn’t want to buy U.S. companies or foreign companies as they didn’t want the added hassle (i.e. currency conversions, currency risk, political situation south of the border, filling out additional tax forms).
Once we explain to clients that the process is rather straightforward then most agree that it makes sense to diversify some funds to companies outside of ÎÚÑ»´«Ã½.
6) Buying yield
I’ve seen many situations where investors will purchase an investment based solely on what a company’s yield is, whether it is a set distribution or dividend yield. Buying on yield alone is not a successful approach. In many cases, companies are paying a dividend, which is not sustainable. What you will find is that many of these high yielding companies will be forced to cut their dividends or eliminate them all together, which in turn will typically result in the share price dropping in value as investors sell the company. Dividends are only one portion of the overall rate of return.
We always tell clients that you have to factor in the change in the shares price, as well as the dividend, to obtain the total rate of return. Investors who only purchase companies that have a dividend over a certain threshold, are often times missing out on some of the best companies in the world. Many good companies either pay a minimal dividend or no dividend at all.
7) Share price
Over the years, I have heard investors look at the share price alone and determine whether or not the company is a good purchase.
Share price has very little to do with whether a company is worth purchasing. Profitable companies that do not pay a dividend often have more growth in their share price. These growth companies are also reinvesting their excess cash into their own business to help it grow rather than paying out excess cash to investors.
If a company doesn’t pay out the majority of its earnings then you normally expect more upward movement in the share price. In many situations, a company has chosen not to split their shares ever, or infrequently.
8) Never selling
There are a few reasons why investors do not want to sell a holding. It could be a belief that the investment can continue to go higher in price, hoping that an investment that has lost a lot of value will "come back" one day, or a feeling of loyalty because a relative works for that particular company. None of these is a sound investment decision.
The result of never selling is that you can end up with too much concentration in one holding and increasing the risk of your portfolio. More typically, you end up holding on to underperforming companies.
9) Excessive debt
Prior to investing in any company, it is worth looking at both the current ratio and the debt to equity ratio. The current ratio is one of the easier accounting ratios, if you have the financial statements. You simply look at the current assets that could be cash, short term investments (due within one year), inventory, and receivables. You then look at the current liabilities which can include accounts payable and interest payments (for the next 12 months) on long-term debt.
Once you have these numbers you then look to see which is higher. If the current liabilities number is higher than the current assets then there are issues in the company being able to pay their current liabilities which may require selling some of their long term assets or going into more debt to pay their current debt.
Either way, there are a lot of profitable companies out there that do not have excessive debt and would be worth looking at over a company with excessive debt. Too often we feel investors purchase highly levered companies that are destined to have challenges ahead if any bumps occur (i.e. operation challenges, slumping commodity prices, slowing economy).
10) Buy high and sell low
Perhaps the biggest mistakes that investors make is buying stocks at market highs and then selling good quality investments at low points in the market and then staying out of the markets until the markets recover again. This is not a successful longer term strategy.
History clearly tells us that when the markets have declined to a level where you feel things are stabilizing it is the time to buy. Any time that the markets have declined 15 per cent or greater typically makes great entry points to purchase good quality equities. Creating your wish list of equities and executing on the buys before the markets fully recovers. It is important to stick to the best quality companies that are able withstand further declines in the short term.
When you look further down the road I suspect that you’ll be pleased with the purchases, if you have purchased at lower levels.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138.
