Current Allocation for January 2011
After some big changes, I’m closing out some large short-term holdings and finally moving towards a more consistent long-term investment plan. This makes it a good time to review my allocation! I did some quick data gathering and found the following information:
- DEX Universe Bond Index – 3.22% yield to maturity, 6.21 duration
- S&P TSX – 19.73 P/E, 5.1% earnings yield, 2.43% dividend yield
- S&P 500 – 19.58 P/E, 5.1% earnings yield, 1.77% dividend yield
- EAFE – 18.6 P/E, 5.4% earnings yield, 2.35% dividend yield
The first thing that jumped out at me is that the equity indexes are remarkably similar. Although there are additional transaction and taxation costs for the foreign ones it’s close enough that trying to put a few more percent into one would be all but worthless based on a look at current valuations. If you have an opinion about which market will do better that’s another matter but I’m not going there at this point. Based on these I will follow this allocation going forward in the next year:
- 20% medium-term bonds (DEX Universe)
- 26.66% Canadian equities
- 26.66% US equities
- 26.66% International developed equities
This is not complicated at all, and you can see that I’m not putting a whole lot of fine-tuned predictions into it. At the current stage TD e-Series funds make it simple and cheap so the choices are limited a bit but that’s ok with me. Although I’m not worrying about 26% vs 28%, I do have a few expectations behind these allocations.
First, with equities getting close to a 20x P/E they still have room to rise quite a bit if more money flows into the markets but if that happens they’ll become increasingly overvalued. It’s also entirely possible that equity markets could drop over the next year with fresh news. If investor expectations decline they don’t have the support of undervalued prices to soften the fall. In the long run if we keep the number of investors who were in the market from the 80s to the 2000s, 19x is not an exceptionally high ratio and on that basis a heavy tilt towards equities works for me.
You may say that I can eliminate bonds entirely and just diversify the equities to get a higher return. This is a valid point as diversification works most of the time. So why do I keep bonds? The premium in the equity earnings yield is around 2% more than the bonds, which may not be far off the long-run average but doesn’t suggest that the additional return they may have over the next 3-5 years comes at a low relative risk like a 5% premium would. The bonds may reduce the returns but it’s not a certainty.
Finally, everyone knows that interest rates will rise and hurt long-term bond holders. Why not use a shorter-term index? If I was using the full range of ETFs I might well split the allocation, but I wouldn’t give up on longer bonds at this point (and they’re still less than a 10 year duration). I know that everyone knows interest rates will rise, and I know that yields have already been pushed up to some degree by the expectation. There will undoubtedly be rate increases and capital losses, but if those coincide well with volatility in equities I may actually get a profit from rebalancing.
The main weakness in this line of thought is that another thing driving bond yields down is the number of investors who are avoiding equities. Regardless of expectations, if there is a rapid exit from the bond market values will fall. This is a possible threat but overall I’m comfortable with the returns and potential for rebalancing this gives me.