There have been several requests for us to touch on allocations in one of our newsletters, so today we’ll do just that.
But first, we do want to mention that Module 2 of our NFT course is available to Premium members!
Remember, this course, along with the Stocktrades NFT itself, will be available free to Premium members who opt-in for the sale.
Owning the NFT will also give you the ability to buy and sell memberships, and will make Stocktrades the first platform of its kind to have this type of functionality. We will speak more on Module 2 at the end of this e-mail.
For now, let’s get to portfolio allocations
First, it’s important to note that we will not talk about specific allocation targets. Why?
In reality, portfolio composition and how one constructs a portfolio will differ depending on the individual. For example, someone with a much longer time horizon may allocate more of their portfolio to the growing technology sector over the income-based utility or telecom sectors.
With that in mind, we can still talk about different approaches to allocations and some strategies accordingly. First, let’s talk about the basics.
What do we mean by portfolio allocation?
We are talking about portfolio composition, and how one allocates a certain percentage of their portfolio to a particular position.
There are no hard and fast rules here, but allocation is typically determined by one’s risk tolerance. Case in point, an investor with lower risk tolerance is likely going to lean towards a well-diversified portfolio.
On the flip side, someone with a higher risk tolerance may be more comfortable with less diversification and going overweight in certain positions or sectors.
Why diversify?
The main purpose of diversification is to reduce unsystematic risk. What exactly is unsystematic risk? It is risk you can make an effort to avoid, while systematic risk is the risk that cannot be avoided.
Think of it this way. You can reduce your exposure to the rise and fall of commodity prices by limiting your overall energy or material exposure. This is unsystematic risk. However, you cannot diversify to protect your portfolio from an event like a war, weather event, terrorism, or natural disasters. These are systematic risks.
In the simplest way possible, unsystematic risk can be mitigated through diversification, systematic risk cannot. Just based on this alone, you can see how allocation all ties back to risk tolerance and is likely the driving factor behind selecting positions.
Allocation based on Sector/Industry
This is by far the most common way investors will look to allocate their positions. Why? It is pretty cut and dry and the easiest to implement.
All stocks will fall under one of the sectors as outlined by the Global Industry Classification Standard (GICS). Up until 2016, there were only 10 sectors, but Real Estate was subsequently added and there are now 11:
· Energy
· Materials
· Industrials
· Consumer Staples
· Consumer Discretionary
· Healthcare
· Communication Services
· Utilities
· Financials
· Information Technology
· Real Estate
There are also dozens and hundreds of industry and sub-industry categorizations within each sector.
The easy play here is to just allocate an equal amount to each sector and even split them by sub-industry. While that may seem simple enough, it can get quite complicated when one gets into the industries & sub-industries. This can lead to having too many positions.
While there is no set number of positions, our view is that investors should only hold the number of stocks that they can effectively monitor. For example, if an investor can’t effectively stay on top of 30-40 stocks then they may want to consider cutting that down to 20 stocks. If they can’t manage 20, maybe 10.
(We do hope that Stocktrades Premium is helping you become more comfortable with a wider selection of holdings due to the time savings of our quarterly overview of earnings and the updating of our reports.)
Research has varied in the area of allocation, but most studies agree that the benefits of diversification seem to top out between 20-30 stocks. What does this mean? If you are buying 50 stocks just to diversify, it is not having a material benefit in reducing unsystematic risk.
In other words, for every stock added over this amount, there is only a small incremental diversification benefit, likely not worth the amount of time it will take you to manage that holding.
There may be a good reason to be overweight in one sector vs another
Case in point, over the past year anyone who was overweight Energy, REITs, and Financials, has likely outperformed. While anyone overweight tech would have underperformed. However, prior to the pandemic, the IT sector was one of the best performing sectors for almost a decade.
If you were a member in early 2021, you may have remembered us re-allocating every one of our model portfolios in February. We reduced bond exposure and increased our exposure to the Financial and REIT sector.
This is the perfect example of making adjustments to your portfolio on the fly to help protect yourself from increased risks. In early 2021, it was primarily inflation worries, which have proven to be a large issue a year later.
There is also a misconception that Indexes are perfectly balanced in this area and will give you proper allocation – they aren’t
For example, the S&P/TSX Composite index is heavily weighted towards Financials and Energy (48%), and as a result is underweight several sectors.
Many investors would never individually structure their portfolio to be nearly 50% financials and energy. But, some who maybe buy index funds simply because it is viewed as the safer strategy by many may not realize how exposed they are. Make sure you have images enabled to see the actual chart of allocations below.
Even the S&P 500, which is typically used as the standard for the North American stock market is imbalanced.
As you can see above, 30% of the S&P 500 at the time of writing is technology companies. 30% is relatively high exposure to any particular sector. But, technology, which is capable of being pretty volatile, more so than something like a utility, may not be optimal for some.
So, don’t be fooled into thinking that if you buy an S&P 500 or TSX Composite index fund you have the ideal allocations – you may not.
I say ‘may’ because you might be completely comfortable with the allocations provided by these Indices, it all depends on the individual investor.
In principle, it seems easy to allocate by sector, but it is not an easy task
While difficult, however, it is one of the best ways to diversify and as you can see, it is one of the main reasons why we believe investors need to look outside of Canada when constructing their portfolios.
Canada’s main Index the Toronto Stock Exchange is heavily exposed to cyclicals. This can cause a pretty vicious cycle of outperformance during commodity booms, and underperformance during commodity busts.
Another consideration for allocations is geography. As we’ve seen above, home bias in Canada could lead to an imbalanced portfolio. There are next to no healthcare stocks on the TSX, and the US has far more reliable options in this area.
Allocating by country is certainly more difficult than it used to be thanks in large part to globalization. Shopify (SHOP) for example, is a Canadian company that has operations worldwide. So while it is a Canadian stock, it is far less reliant on the Canadian economy.
Another example is National Bank (NA). The company generated 85% of its revenue in Canada (52% from Quebec). As a result, National Bank is a far more geographically concentrated play than some of the other Big Banks which have a large presence globally.
In fact, because of Canada’s Big Bank exposure south of the border, both Mat and I have never found any need to own US banks. So despite a company like the Bank of Montreal being a Canadian corporation, it still exposes you to the US economy. For a company like Royal Bank, they have exposure to nearly 40 different countries.
Our final example relates directly to the ongoing war in Ukraine. Gold stocks have been strong performers, but Kinross gold has struggled. Why? In 2021, 23% of its output came from the Kupol mine in Siberia which has now been shut down because of Russian sanctions.
There are countless examples of gold companies that have been impacted by geopolitical risks in unstable countries. It is why we’ve always advocated for gold producers that have the majority of operations in geo-stable countries like Canada, the U.S., and Australia.
There are many complexities when deciding to allocate a certain position of your portfolio to a particular geography
It is not as simple as – I’m going to allocate 70% of my portfolio to Canadian stocks, 20% to U.S. stocks, and 10% to emerging markets. While it’s possible, you’ll want to ensure you take these complexities into account.
The final allocation strategy we’ll talk about relates directly to growth stocks. One common approach is to allocate a certain percentage of your portfolio to foundational stocks (core stocks that are usually blue-chip in nature, and often pay a dividend) and then a percentage to growth stocks.
This is certainly how we do it here at Stocktrades Premium, and this is how both Mat and I’s portfolios are constructed as well. In fact, just over 60% of my portfolio (Dan) is concentrated in the Canadian and US Foundational Stocks featured here at Premium.
Once again, how those allocations line up will depend on risk tolerance. A higher risk profile is likely to have a much higher allocation to growth stocks versus the defensive investor.
It is also important to note, that you can combine all these strategies into one comprehensive portfolio allocation. The key, however, is to allocate based on risk tolerance and to have a plan.
If you don’t want any individual stock, industry, sector, geography, or type, to exceed a certain percentage, then rebalance accordingly. This can be done by either selling or adding new money to other positions.
As mentioned at the start of this email, it is impossible to recommend a certain % allocation on any one stock, sector, geography, or type
Why? Because every individual is at a different stage in their investing lifecycle. One who is just starting out and in their mid-20s will likely have much different allocations than someone at or close to retirement.
The key takeaway is that there is no right way to allocate positions within one’s portfolio. What is important, however, is that you have a plan that is within your risk tolerance and that you stick to that plan.
It may sound simple, but if you are losing sleep over your positions, it is likely that your allocations are not in line with your risk tolerance.
Here are some key rules that both Mat & I use to help us with our allocations. Again, this is far from a templated portfolio. Our experience in the markets includes several drawdowns and bull runs over the years, and this has allowed us to find a portfolio that suits our overall risk tolerance.
If you’re new to investing, it is likely you’ll need to do the same. Risk tolerance is something that is rarely known when you start. It is often realized through your first drawdown, which is what a lot of investors who started in 2020/2021 are experiencing now, that you become aware of your true appetite for risk.
Our primary diversification strategies:
– No individual position greater than 5% (may let it run by a couple of % points)
– No individual growth stock greater than 2%
– No individual sector greater than 20%
– Geographical breakdown – 60% Canada, 30% US, 10% Emerging markets for Mat. For myself, I sit at around 75% Canadian, 20% US, and 5% cash. I have increased my Canadian exposure by a wide margin over the last few years as Canadian stocks are presenting much better value than their US counterparts.
– 30%~ growth exposure. We will look to reduce this as we get older.
NFT Module 2 – How to opt in to the sale and how to gain access
Module 1 of our NFT course covered what an NFT actually is (an eye-opener for 99% of those who went through it).
Now in Module 2, we’ll go over NFT specific terminology that will not only educate you even further in the world of NFTs but will also help you understand the lingo.
Much like P/E, P/S, FCF, and EBITDA, the NFT world has some terminology that is relatively simple in nature but needs to be understood, or else conversations can seem… incomprehensible.
In terms of opting in for the sale, simply head to the Discord and follow the instructions. We cannot really think of a logical reason for a Premium member to not participate, as these NFTs will sell to the public for around $250 CAD.
But, we do realize that it can be a confusing process for many, which is why we released this course and is why we will be walking Premium members through the process, start to finish.
If you don’t have Discord, feel free to simply reply to this e-mail if you haven’t already and we will get you on the list.
