3 easy steps to a fully diversified retirement portfolio

I am always surprised how much confusion exists regarding various account types and investment options. The majority of people I talk to either do not have an investment account at all, or if they do, it contains some mutual funds that the guy or girl at their local branch recommended. I think what scares most people off is the financial industry’s love for acronyms and making simple things seems difficult.

I work in the financial industry and I can tell you it’s not coincidence that you’re finding it hard to understand. It is in the industry’s favor to make things seem difficult and confusing, so that you do not try to do anything yourself. This is what makes their revenue flow and profits grow, and it the end, it makes you that much poorer. While picking individual stocks and analyzing companies is in fact complicated, the approach I’m about to outline is not only easy, but is likely to work for you far better than paying for stock picking and analysis. (not convinced? See the most up-to-date analysis here)

In my previous posts I’ve already discussed why investing in the stock market over the long term is near risk free, but I’ve never really explained how to practically do it. Without further delay then, the 3 steps to a full diversified portfolio

Step #1 – Establish a self-directed investment account

There are plenty of brokers out there but the best option for simplicities sake is to go with whoever you already bank with. All the big 5 banks in Canada have what are called “discount brokerages” which offer self-directed accounts (RBC Direct, TD Waterhouse, BMO InvestorLine, CIBC Investor’s Edge and Scotia iTRADE) . The nice thing about going with your bank is that your account will be integrated with all your other internet banking and moving money between accounts will be very easy.

One thing to keep in mind is that an account is not an investment. Technically you do not invest into an RRSP or a TFSA but you contribute or deposit money into it. You then use that money to purchase investments. This is an important distinction because it underlines that you can choose the same investment regardless of which account you choose.

If you don’t already have a self-directed investing account you should set one up as soon as possible. There are 3 major account types for individual investors under the age of 65. I list them in the order of importance.

  1. RRSP (called an IRA in the US) – contributions to these accounts are deducted from your income for tax purposes. In other words the government gives you an interest free loan for somewhere between 30% and 50%  of what you contribute. Best of all this loan may never really have to be paid back, or at least not in full. It’s like getting an immediate return on investment between 30% to 50% and is the single most powerful way to build wealth for individual Canadians. In addition any investment returns you generate in this type of account are generated completely tax free.
  2. TFSA (called a Roth IRA in the US) – contributions are NOT tax deductible, however, you can withdraw the money tax free at any time. The investment returns in this type of account are mostly tax free. There are some exceptions but describing them goes beyond the scope of this article. These are best if you have either maxed out your RRSP contribution room or if know you will need the money before retirement.
  3. Regular/Margin – these are regular fully taxable investment accounts and should only be used if you have exhausted both your RRSP and TFSA room.

One note of caution on the RRSP. The amount you are allowed to contribute is cumulative, so if you have a Mutual Fund RRSP account or an RSP plan at work, you may have already used up some of your room. Talk to your HR department.

Step #2 – Figure out the allocation that is best for you

The 60/40 rule has been used for over 70 years as a default “balanced” stock/bond allocation. It means that 60% of your portfolio should be in stocks while 40% should be in bonds. Most financial advisers use this as a starting point but make various adjustments based on a number of factors. The most important adjustment is based on the age of the investor and how long they have until retirement.

The rule of thumb generally used is to take 100, 110 or 120 and minus your age to get at a stock allocation. This is an oversimplification because it fails to consider that one 30 year old is not necessarily in the same stage of life as another 30 year old. However it is generally a good starting point and will work well for the “average” investor.

The reason this simple rule works rather well is because, during the wealth accumulation phase of an individuals life, the exact allocation of their retirement savings is not all that important. This is because over a long enough period of time the stock market always ends up providing a solid return.  The purpose of the bond part of the portfolio is to reduce the volatility (ie. large swings up and/or down in the value) of the overall portfolio and help you stay on track. However, if you close your eyes, and wake up 25 years later, the best return is still achieved by going 100% stock.

The calculations are very different if you are either nearing or in retirement. In that case the primary purpose of an allocation is to provide you with a steady stream of income that can support your life style. Because life styles and incomes vary so much and because the consequences of not getting this calculation exactly right are far more serious I am going to stay away from suggesting allocations for anyone over 55. If you are near or in retirement I strongly advise you to hire a professional adviser to help you structure your portfolio.

Having said all that, assuming the following:

  • You are putting this money away for a minimum of 15 years and have no need for withdrawals
  • You are not already retired

Here are the approximate allocations based on a 120 – your age calculation:

Age 20-30 30-40 40-50 50-55
Stocks 100% 90% 80% 65%
Bonds 0% 10% 20% 35%

I chose 120 instead of 110 or 100 for the following two reasons

  1. Interest rates are near 0, therefore upside for bond investments is limited while downside is significant. A very minor move in interest rates can destroy decades of returns. Allocating a large percentage to bonds right now is the equivalent of picking up pennies in front of a steamroller.
  2. Volatility (up and down swings in value) of your portfolio is not an actual risk if you plan to keep your money invested for over 15 years. Why not get paid more to take this volatility on?

I am sure I will hear comments from various corners that the allocations I’m suggesting are too aggressive. The truth is there is no standard in the financial world and for every 10 people you ask you will get 20 answers. I think getting too hung up on whether someone should have 10%, 20% or 30% allocated to bonds makes people paralyzed with fear and prevents them from investing all together. Remember, in the grand scheme of things, the exact allocation matters far less than minimizing your fees and being in the market in the first place. Speaking of minimizing fees…

Step #3 – Use ultra-cheap ETFs to construct your balanced diversified portfolio

Exchange traded funds are similar to mutual funds except they are traded on stock exchanges. This gives them the following advantages:

  1. Since any financial institution can sell an ETF on the US or Canadian markets it means a much larger selection than your local bank offers in mutual funds.
  2. The huge number of investors and assets in ETFs means the management fees (MER) are kept ridiculously low. None of the funds I’m about to describe charge more than 0.2%. That’s not a typo, it’s less than one fifth of a percent.

The ETFs I suggest to build your quick fully diversified portfolio are all from Vanguard, a company that prides itself on having the lowest management fees in the world. The funds can be bought using your self-directed brokerage account, just like you would buy any other stock being traded on a US stock market exchange. The difference being that you’re not just buying a single stock but rather thousands of stocks and/or bonds that cover virtually the entire world of invest-able assets.

VT – Buying this ETF is equivalent to buying 7,137 different stocks/companies in 48 different countries across every sector of the world economy. This fund charges a 0.17% annual management fee. A similar mutual fund would charge around 2.3%. That’s a savings of $2,130 in fees over 10 years for every $10,000 invested.

BND – This ETF is the equivalent of investing in 6,512 different high grade bonds across the US bond market. 63.4% are classified as US government bonds and therefore can be considered default risk free. For this one you will pay a 0.07% annual management fee. A similar mutual fund would charge around 1.4%. That’s a savings of $1,330 in fees over 10 years for every $10,000 invested.

BNDX – This ETF is the equivalent of investing in 3,613 different high grade bonds across 98 different countries (outside of the US). This one charges a whopping 0.19% management fee. Once again a similar mutual fund would charge around 1.7%. That’s a savings of $1,510 in fees over 10 years for every $10,000 invested.

The following allocations would be excellent suggestions and cost you little to nothing in expenses.

Age 20-30 30-40 40-50 50-55
VT 100% 90% 80% 65%
BND 0% 5% 15% 25%
BNDX 0% 5% 5% 10%

Or if you hate percentages, the following per each $1,000 invested

Age 20-30 30-40 40-50 50-55
VT $1,000.00 $900.00 $800.00 $650.00
BND $0.00 $50.00 $150.00 $250.00
BNDX $0.00 $50.00 $50.00 $100.00

For example, if you have $10,000 to invest and you are between 30-40 you should buy the following amounts:

10 * $900 = $9,000 of VT
10 * $50 = $500 of BND
10 * $50 = $500 of BNDX

One note of caution is that all the above funds trade in US dollars. Therefore first convert your Canadian Dollars to US Dollars at whatever rate your bank is offering before calculating how many shares of each fund to buy (or you can use this handy little excel spreadsheet to calculate the # of shares to buy).

I bought the funds, now what?

Now you forget all about investing and NEVER check your account until you retire!

I’m actually only half joking as you’d be surprised how well this approach would work! The biggest risk to a long term investor is checking their portfolio too often.

Hyperbole aside, you should in fact re-align the allocation as you age and go into different age thresholds. Eventually you’ll move from your 30’s to your 40’s and as you do you should put more money into bonds. This is the only action I would strongly recommend for everyone.

If you want to do even better than this, you should check your portfolio no more than once a year, and re-balance it to the target allocations you chose when you first started. There are a couple of reasons why the portfolio will get misaligned over time without you changing anything:

  1. The prices of the funds fluctuate in different directions and by different amounts. This causes you to become over-allocated to the “winning” funds and under-allocated to the “losing” funds. Re-balancing forces you to buy a little of the “loser” fund while selling a bit of the “winner” fund to keep your allocation in-line.
  2. The funds pay you dividends which are cash payments that get accumulated in a cash balance in your account. This means your allocation to non-return bearing cash increases over time. This cash balance should be periodically invested using the same target allocations as the rest of the portfolio.

Once again if you choose not to re-balance regularly it does not mean you’ll do badly. You might do slightly worse than a regularly re-balanced portfolio, but still far better than letting your money sit in a savings account or pre-paying your mortgage. Therefore don’t let this stop you from putting your money to work.

In general there is really no need to check up on your investments or “watch the markets”. There are no tenants (real estate) here to check up on, no quarterly reports to read (individual stocks) to make sure management isn’t embezzling money, and no employees slacking off at work and alienating customers (small business). Since you are invested in literally the entire world economy you are protected against any particular part of it failing. If Tesla is a flop, then maybe GM and Honda will take over the market and make you rich, if Tesla ends up dominating the car industry that’s great for you too. If the car industry fails entirely and cars get replaced by Star Trek-like transporter machines, you will own the company that makes those transporter machines and benefit regardless.

The only risk you have is the entire the world economy imploding in on itself and everyone going berserk Mad Max style. Something tells me in that scenario your retirement portfolio would be the least of your worries!

Note: This article does not mean to imply hiring a financial adviser is a bad idea. There are plenty of wonderful girls and guys out there helping to keep people on track to reach their financial goals. The service a good adviser provides minimizes your costs, stops you from making emotional decisions, tweaks your allocation to better suit your risk profile and helps you with tax implications and planning. They are also very likely to use ETFs similar to the ones I’ve described in this article when constructing your portfolio. However, if your financial adviser thinks their primary job is to “pick the best stocks”, run as fast you can!

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2 thoughts on “3 easy steps to a fully diversified retirement portfolio

  1. dkaban

    Thanks for this article, I’m actually going to talk to my financial advisor tomorrow and am looking in to your suggestions, as a 20 something I’m new to the investing game but very keen on learning. Going to talk to them about VT as you mentioned, as awell as BD and BNDX.

  2. Unassuming Banker Post author

    Hi Dustin, Thank you for your comment. It’s great to hear that you are starting early because the earlier you start the easier it is. At your age I would take ever opportunity to put any extra money to work in the market. You have decades to make it work which puts you in a great position.

Let me know what you think