Success secrets from the smart money

Difficult decisions get easier when we get advice from those whose judgment we respect. For investing decisions, I suggest taking a page from the handbook of pension fund managers.

To be sure, many institutional strategies aren’t suited to you and me, but we can all learn from the smart money. For almost eight years, Doug Cronk has used his blog (dougcronk.wordpress.com) to make that argument. Cronk has spent 25 years in money management, most recently as director of client relations for Alberta Investment Management (AIMCo), which manages more than $75 billion in institutional funds. Here are some of the success secrets he’s learned over the years.

Asset allocation is paramount. Open the annual report of any pension fund and you’ll find a pie chart displaying the portion of the fund invested in Canadian stocks, foreign stocks, bonds, real estate and other asset classes. That mix—not the specific investments you select—will have the greatest influence on a portfolio’s long-term performance. “That decision gets you in the ballpark,” Cronk says. “From there it takes some huge errors to screw it up.”

What’s the right asset allocation for you? That depends on a number of factors, including your time horizon, your ability to sleep during a bear market, and the rate of return you need to achieve your goals. Cronk suggests you start by looking to the Pension Investment Association of Canada (PIAC), which publishes the average asset mix of its members (visit www.piacweb.org and click Publications). In 2013, its defined benefit plans averaged about 29% bonds, 12% Canadian equities, 29% foreign equities and 10% real estate (the remainder was private equity, infrastructure and other assets).

Notice that bonds still make up a big slice of the pie, despite today’s low interest rates. “Regardless of what pension fund you look at, the bonds almost always come in at roughly 30%,” Cronk explains, “and that hasn’t changed significantly for a long time.”

Remember that rising rates would actually benefit investors in the accumulation phase, because it would mean higher expected returns on bonds. “When interest rates move up, the liabilities move down in the pension world,” Cronk says, “but individuals don’t think that way.”

Move away from home. Canadians love homegrown companies, and many keep most or even all their holdings in domestic stocks. Compare that to just 12% for the PIAC member funds.

“I don’t think people realize how small and how volatile the Canadian market is,” Cronk says. Over the 25 years ending August 31, the S&P/TSX 60 index of large Canadian stocks had an annual standard deviation of 15.3%. (Standard deviation measures volatility: the higher the number, the more returns vary from year to year.) A portfolio divided equally among Canadian, U.S. and international stocks (the same mix in the MoneySense Global Couch Potato portfolio) was about 20% less volatile.

Follow an investment policy. Imagine yourself explaining your investment strategy to board members, the way a pension fund manager would. If you can’t articulate it in a few sentences, you probably don’t have a coherent strategy.

A Couch Potato investor might put it like this: “I plan to save 8% of my pre-tax income and invest it in a portfolio of 30% bond ETFs and 70% stock ETFs, divided equally among Canadian, U.S. and international equities. I will rebalance back to these targets annually. My long-term target rate of return is 6% and I am prepared for an annual loss of up to 30%. I expect to retire in 15 years with a portfolio of approximately $500,000.”

Long-term is longer than you think. Ask the average investor how his or her portfolio is performing and you’re likely to hear about the last six to 12 months. Put that question to a pension fund manager and the answer will be something like, “Our actuaries have confirmed the fund is on track to meet its future liabilities based on current contribution rates.” As the Canada Pension Plan’s website states, “We invest not for the quarter but for the quarter century.” In fact, Cronk says, the CPP’s actuarial projections go out 75 years.

You might argue that a pension fund has a much longer time horizon than any individual—and that’s true to a point. But if you’re 50 years old and plan to retire at 65, you’re not just planning for 15 years. Your portfolio needs to last until you die—or longer if you’re planning to leave a legacy. That means your “future liabilities” may extend 40 or 50 years, or even more. When you adopt that perspective it can help you ignore short-term performance.

If you only remember one lesson from the smart money, Cronk wants it to be this: “Get an asset mix, stick to it consistently and tune out the day-to-day noise. Balance is always the key: no extremes. Unfortunately, it takes people a long time to learn that lesson.”

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog.