Common sense anyone?

There’s no way to describe the current financial crisis except as sharp, unpredictable, and enduring. Investors have witnessed a meltdown in assets that for most is uncharted. Few have been unscathed by this tidal wave of de-leveraging of assets caused by a freeze-up in credit markets.

But despite the severity of this correction, the critical thing to remember is that this time it is not different. Global credit markets will eventually thaw and economies will begin to thrive again. The main lesson prudent investors can learn from these difficult times is on the perspective of risk management through asset allocation and diversity within the asset classes, which should be rigorously applied.

An evolving, increasingly complex financial system calls for an updated philosophy of asset allocation. One truth that remains intact, and has been proven time and again, is that asset allocation is the most important determinant of portfolio returns and investing.

An investor’s decision to purchase value versus growth stocks, or to pursue active versus passive strategies, will not make a difference in the long term. Common sense is often not so common, even for the highest of intellects. Traditional asset allocation is a mix of cash, fixed income, and equities. Here’s the problem: As practitioners, we need to do a better job minimizing risk, and maximizing returns within the confines of these components.

Let’s start with the cash component within the asset allocation mix. This should be the safest, most riskaverse component of a portfolio, but it wasn’t long ago that many investors and advisors were allocating close to 100% of cash investments to the commercial paper of only one or two issuers. These people are still reeling from the fallout of asset-backed commercial paper markets. In today’s climate, these types of blunders could be deadly, yet they’re completely avoidable. Investors naturally gravitate toward vehicles offering the greatest return. Greed can be a good thing but not when it comes to money market investing. So nothing should be taken for granted. There’s no need to go further than R1 high-rated third-party asset-backed commercial paper. In today’s fast and dynamic business environment, a business’s fortunes can change quickly and without notice—remember the lesson of Lehman Brothers. So what should investors do?

This is no easy question. The highest-rated traditional money market instruments are R1-high government treasury bills or one of the big five Canadian banks’ short-term instruments (bankers’ acceptances, bearer deposit notes, or GICs), or commercial paper from a corporation. One could theoretically create a well-diversified portfolio of these instruments but in practice it would be very time-consuming and labourintensive given their short-term nature. Depending on the size of capital involved, it would be best to buy a Canadian bank-issued money market fund that will only invest in these traditional investments. One thing is certain: Buying anything non-traditional is an absolute no-no.

The second lesson pertains to the fixed-income component of the asset allocation mix. Fixed-income investments should be kept simple.

Chasing extra basis points through high-yielding issuers does little to enhance performance and seldom changes an investor’s lifestyle in any meaningful way.

Portfolios must also have diverse issuers. A well-balanced, fixed-income portfolio may include issuers through the government (federal, federal government- backed agencies, and provincial bonds), Canadian big five banks, and top-quality corporate bonds, rated A or better. A conservative investor should not venture beyond these con- fines to grab extra yield by going below an A credit quality, because it’s impossible to predict interest rates with precision. Therefore a laddered approach to managing the duration of the investment is the most simple and effective strategy for the majority of retail investors looking to lower interest rate risk within a portfolio. For most investors it doesn’t make sense to have an average duration longer than five to seven years. If one ventures past this duration, the ensuing price volatility defeats the raison d’être of fixed income despite the benefits realized by trying to play the yield curve.

For taxable accounts, depending on the objective of a fixed-income investor, it may make sense to introduce retractable or fixed/reset bank-preferred shares. Preferred shares contain more risk than debt, and inconceivable events do occasionally occur especially under the current volatile conditions. Fannie Mae and Freddie Mac are apt examples. Preferred share owners were wiped out in 2008 but the U.S. government rescued the bondholders by taking implied guarantees and turning them into explicit guarantees.

The last lesson to be learned is in the equity component of asset allocation. In 2008, there was no escaping the carnage of equity markets, regardless of sector or stock selections by even the most astute investors. Moreover, international investing offered little benefit as global stock markets were the most correlated in history. The global economy is now so interconnected that many of the historic benefits of investing in international markets that once lowered risk in an overall portfolio have been muted. Style diversification through investments in small or large cap stocks, or value versus growth disciplines also failed to provide shelter.

History has proven that consistently timing the bond and stock markets is a statistical impossibility. But with appropriate risk controls, one is able to outperform the benchmarks in North America on a risk-adjusted basis over longer periods. The question remains: What steps can an investor take to enhance returns and lower risk in a portfolio?

Canadian equity investors still need to have a significant portion of their equity holdings invested in a diversi- fied selection of quality companies with large market capitalizations. The focus should be on names that have a history of consistently paying and growing their dividends. Currency remains the primary consideration when pondering an investment outside Canada. The concept of global economies being interconnected today will only continue to be strengthened over time. Therefore, there’s no need to have as much international diversification as you might think and the winning strategy will be choosing companies that benefit from this global reality.

Successful equity managers understand their style at its core. In my group’s case, our core Canadian and U.S. equity strategies utilize a quantitative approach that removes emotion from investing and keeps subjectivity to a minimum. The Canadian and U.S. Equity models we apply concentrate principally in the largest capitalized businesses in North America. We don’t differentiate between value and growth. We look for basic characteristics that any prudent businessperson would seek when evaluating the investment merits of a company. Some of the main factors exhibited in our portfolios include consistent growth in sales, earnings, and dividends.

After these screens, the deciding metric of highest dividend yield is applied to select the top 20-to-30 securities while seeking high return on equity. Factors remain constant, but we do re-adjustments to our models a number of times a year as companies release updated results. Our U.S. equity portfolio avoided having any troubled major bank in 2008 due to this common-sense methodology. Risk management is another key aspect of our strategy and that’s why we adopt an equal weighting of all our selected securities and are mindful to not veer much from the respective benchmark’s industry weightings.

Assuming the core portfolio is well designed, it’s necessary to add an aspect of uncorrelated style diversification to the mix to help lower risk. What matters most is limiting the severity of a loss and having the realistic ability to recover through a well-designed and prudent strategy. We’re comfortable with our style and competency but realize adding satellite positions offered by other managers provides the valued benefit of lowering overall portfolio risk. Unfortunately in an unforgiving down market it’s almost impossible to avoid loss for a long-only manager.

In the end, it’s we, the managers, who must audit our models, explore new metrics and remain disciplined despite living in an age where changing investing strategies is as easy as the push of a button. As we move into the future, prudent investment advisors will continue to question everything and take nothing for granted.