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What are the benefits of using a portfolio approach?

The risk level of a total portfolio is almost always less than the risks of the individual investments it contains. This is because investments tend to go up and down at different times. Although the return on your portfolio will be the average of the returns of the investments it holds, you end up with an improved risk return trade-off by using the portfolio approach.

For Canadian investors, having some international equities as part of your asset mix historically has boosted returns while also reducing risk. The investment management process involves several steps, including selecting investments, market timing decisions and portfolio management. Investments can be selected using a variety of techniques, such as fundamental analysis which includes looking at the financial health of a company and its stock. The final step in the investment management process is portfolio management - the management of your investments as a whole, rather than as unrelated individual holdings.

Designing your investment policy

Your investment goals might include having sufficient money for a comfortable retirement starting 25 years from now, or to help pay for your children's education in five years. Deciding on the right types of investments to meet your goals will depend on a range of things. Think how much money you have to invest, the return you will need and when you will need your money back. Whether you require current income and your risk comfort level will also have a bearing on which investments will suit you. How much importance you put on various investment objectives - the three key ones are capital preservation, income and capital growth - will influence how you mix your investments among the three main asset classes: cash, fixed-income and equities.

Example:   If your goal is to retire at age 65, and you, therefore, need an annual return of 10% from your investments to do it, you probably have to include equities in your portfolio to get that much growth.

Your investment goals will drive, at least to some extent, your investment objectives. Investment objectives determine, to a large extent, the kinds of assets you need to reach those goals.

Keep these seven major considerations in mind when you set your investment objectives:

1. Risk

Decide on the amount of risk you are prepared to take and make sure the risk of your overall portfolio matches that risk level.

2. Return

Decide whether you want to maximize return within your risk tolerance, or whether a required minimum return with certainty is preferred, generating only that much return with emphasis on risk reduction.

3. Time horizon

Keep in mind when you may need the money: If you know you will need all of your investment money in a year for a home down payment, it doesn't make sense to have it all invented in stocks. Stocks are a long-term investment which expose you to price volatility, which means you risk having to sell when stock prices may be down.

4. Inflation

Think how much inflation protection you need in your portfolio. If you are retired with a long time horizon and a goal of using your portfolio to generate current income, inflation will be a big concern for you. All investors will be concerned about inflation - to varying degrees.

5. Liquidity

Decide how much cash or cash equivalents you want or need to hold in your portfolio. If you need a large amount of money soon, you may hold a large share of your portfolio in cash. If your income varies, you may need to keep more of your assets in cash than someone with a regular paycheque. Or, if you feel the stock market is overpriced, you might shift some of your assets from stocks to cash, planning to buy back into stocks later when you judge stock prices are more favorable. If the yield curve is inverted and the returns from cash are high, you may switch into cash to take advantage of that.

6. Taxation

Your marginal tax rate will be a major factor when determining which the proportion of your income which you should take as tax-favored dividend income versus interest income.

7. Market timing

Two approaches to investing include buy and hold and market timing. You might use one or the other or a combination. The theory of market timing is simple - you want to buy when an investment is cheap, and sell when its price is high. But market prices, when they change, tend to shift quickly. Most investors are unsuccessful at market timing.