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Nov 22, 2018

Five Key Principles To Build A Portfolio

by Ryan Modesto

Ryan ModestoInvesting and managing your own portfolio can be hard but it doesn’t always have to be. We think if an investor can get a few of the big things right and think long-term, it can go a long way to making their investing journey a smooth one. Of course, this means an investor needs to know what the most important aspects are: Diversification, Costs, Weighting/Positioning, Rebalancing and Tax Efficiency. In our view, if an investor can address these five key principles when setting up their portfolio, they will be well on their way to retirement. The below items assume we already know what an appropriate asset allocation is (i.e. conservative, balanced or growth). Once you know what the general asset allocation should be, you can then start to work at building up to these allocations.


This is the only aspect of finance where investors get a “free lunch”. Everything else has an offset or a give and take. Diversification, however, is the one area where an investor can reduce risk while increasing returns. The basic idea behind diversification is that an investor should hold various assets that move in different ways, which reduces risk and increases returns. Risk reduction occurs from not having all of your eggs in a single basket. If one asset falls, there are ‘X’ others that can go up. The return enhancement comes from a few factors. On one hand, having more investments increases the likelihood an individual holds a winner, opposed to say holding a single stock that has a 50/50 chance of rising. Spreading your investments around should increase the chances that they are correct more often than not. The other benefit of diversification is that it allows an investor to rebalance (another key principle we discuss) and live to fight another day if they make a couple of bad investments.

When we talk about diversification, we are talking about diversification across assets (stocks and bonds), geographies (USA, Canada, emerging markets, international), industries (Technology, Industrials, Financials, etc.) and even style (value and growth) although admittedly this last point may be getting a bit into the “weeds”. In general, a portfolio should have some exposure to all of these different areas. While the amount an individual allocates to a specific area will differ depending on the situation, having the various exposures helps to insulate investors from things out of their control such as a recession occurring in a specific geography, or tariffs impacting a single sector. Perhaps most importantly, diversification allows an investor to make some mistakes and not risk their retirement savings because of a few missteps.

The 5i Research Model Portfolio Approach:

While the model portfolios focus on Canadian equities specifically, we design the portfolios so they are diversified across industries, company size (large and small-cap) and style (value, growth, dividends).


We discuss the importance of managing your cost base and the impact it can have on portfolio values over the long-term in another article. The concept is an important one, especially in a portfolio, since those costs add up over time. What’s more, they are often unseen costs. Your mutual fund, Exchange Traded Funds (ETF) or investment advisor do not send you a receipt every time they bill you. The charges come out of your investments and are less noticeable in a portfolio that moves up and down any given day to begin with. The main reason we think costs deserve to be a key principle is primarily because it is something that is well within the individual’s control. You cannot predict or control what the Toronto Stock Exchange (TSX) is going to do any given year. You can buy low-cost ETFs or talk to an advisor about what value you are getting for your fees. If you can control your costs, which add up over the years, why wouldn’t you? It is important to note here that we are not necessarily saying low-cost is best (although in many cases it is.) Most important here is that an investor is getting value from what they are paying for and not paying for something they could do themselves with ease. Decreasing the costs structure of a portfolio can be immediately influenced by an investor and these changes have a defined and knowable 'return'. Returns like this are hard to come by if not impossible when investing so should be closely considered by all investors. Here are a few ways an investor can control their portfolio costs:

Fund fees: Switching from a high cost fund to a lower one or moving from a high cost active fund that is a closet indexer to an index fund.

Transaction costs: Using a low-cost investment broker to limit charges on trades or calling up the current broker and trying to negotiate lower fees.

Foreign Exchange (FX): Many investors utilize a technique called Norbert’s Gambit as a means to reduce FX conversion fees.

Talk to your advisor: If you have an advisor, you could always just ask about ways to reduce the fee. It does not have to be an adversarial conversation and the advisor should have your best interests in mind and should be happy to find ways to reduce the cost structure. If they balk at the request or shrug it off, this could simply be a red flag as to who the advisor is really looking out for.

The 5i Research Model Portfolio Approach:

We are big fans of low-cost solutions and try to avoid high costs wherever possible. Fortunately, there is no ongoing fee for an investor to access and shadow the models in whichever form they like and the annual rate to gain access to all the 5i services is one of the lowest out there.


This is an important principle to grasp and maybe the most difficult as there is no right answer on position weights. When we are discussing this topic, we are referring to the size of single positions in a portfolio. The key here is that no position is so large that if it does not work out, it puts your retirement goals or financial goals at risk. Position sizes should be set in a way that they allow an investor to make a stumble and easily get back up and continue with the marathon. The other important aspect with position-sizing is that of investor comfort. If a weight is large enough that an individual is losing sleep or feeling stressed about it, then it needs to be reduced. Regardless of whether the positioning is appropriate at face value, investors make the worst decisions when feeling stressed or pressured. Also, investing is supposed to make your life better, not induce stress. So, if investors finds themselves worried about the size of a holding, that is usually a good sign that it is too large and something needs to be done.

We did mention how there is no single answer as to what is appropriate for weightings but there are a few guidelines we think an investor can follow. With an appropriate asset allocation set (60/40 stocks/bonds as an example), we think an investor can view position-sizing at three different levels (note we are taking a view relative to the equity portfolio at this stage, as opposed to relative to the total portfolio that would include fixed income and cash):

Geographic: Ensure the portfolio is not a bet on a single economy or geography. We often see Canadian investors with a geographic concentration to Canada upwards of 80% of the equity portfolio. A good rule of thumb would be that if any single geography is over 65% of a portfolio, it is probably too much.

Industry: Similar to geographic concentrations, a portfolio should not be a bet on a single industry. We often see energy and financial allocations in excess of 50% of a portfolio. This means where oil or financials go, so will your portfolio. As a general rule, we would typically aim to have no more than 25% of an equity portfolio allocated to a single sector (note there can be exceptions for edge cases.)

Individual positions: If we are referring to stocks, we think a position weight of 2.5% to 5% is appropriate depending on the type of holding and risk tolerance of the investor. At less than 2.5%, the odds of a winning stock impacting a portfolio in a material manner is low and it gets closer to an index fund. Above 5% (but closer to 10%), the portfolio then becomes more of a bet on that single security. Again, there is no right answer here as there are many dependencies, but we think this range is a good starting point. One caveat here would be for fund investors. Depending on the fund, in some cases an investor could argue holding only one to five ETFs, so the weighting would obviously be much higher. In general, an investor sees most of the benefits of diversification between 25 and 35 individual holdings. More holdings will not hurt a portfolio, simply the benefits of the additional holdings are greatly diminished at this stage.

The 5i Research Model Portfolio Approach:

We typically define a “full position” as being 5% and a half position as being 2.5%. This way, when a stock we like does well, it helps to benefit the whole portfolio. If an investor is confident in the research they have done and remain diversified, they should let the hard work pay off and contribute to the portfolio through gains. Positions at 1% or less will do very little for most portfolios, even if they double. We aim to hold 20 to 30 positions in the model portfolios.


Rebalancing is a bit of a result from some of the above principles but deserves its own section. The concept of rebalancing is that an investor sells a little bit of their winners and adds it to their losers. This allows some profits to be taken on the way up, manages position sizes (as stocks that are increasing are also getting bigger in the portfolio itself), and moves money from what are likely holdings with higher valuations into names that are lower valuations. There are two main ways an individual can approach rebalancing:

Time based: This one is as simple as setting a date on your calendar (monthly, quarterly, semi-annually or annually) and rebalancing back to your target weights when this date occurs. Some judgement is needed here though; if a position only moves say 1%, it is likely not worth the effort and costs to rebalance it just because the calendar tells you so.

Weighting based: With this approach, an investor would decide a range they are comfortable with an asset to trade within. For a stock it could be a starting weight of 3% and a range of +/- 2%. So, if it hits 5%, it would be sold back to 3% or if it hits 2% it would be bought back to 3%. The hardest part with this approach is deciding what the appropriate range is but this comes down to a personal decision.

The 5i Research Model Portfolio Approach:

At 5i, we like to let winners run. Trimming gains too early can get in the way of momentum and be a case of two steps forward and one step back. This, of course, needs to be balanced and watched closely as big winners can get out of hand if they continue to run. We are generally comfortable with letting a single stock drift to roughly 8% of a portfolio but will look to aggressively trim it back at this point. We continually monitor the portfolios and look for opportunities to rebalance through notifications to members on a bi-weekly basis.

Tax Efficiency

Similar to cost, we like this area because it is something that an investor can impact on their own and see a definitive result from. This topic can get complicated depending on the individual but there are some easy things an investor can look at to ensure they are investing in a tax efficient manner. The first is to ensure you are utilizing all tax efficient accounts such as a Tax-Free Savings Account (TFSA), Registered Retirement Savings Plan (RRSP) and an Registered Education Savings Plan (RESP). Having and funding these accounts is a big step in the right direction. The next step would be to ensure the appropriate holdings are within each account. There is no definitive way to do this, but the general rule of thumb is that items that have a higher tax base should be held in a tax efficient account. This means fixed income is likely the most appropriate asset to hold in an RRSP and TFSA as they are taxed as income. We do note, that if your situation is such that you don’t need/have much in the way of bonds, it does not mean you should not use these accounts. If there is idle cash in almost all cases we think it should be put to work in a tax efficient account. If you hold US dividend payers, these are likely most appropriate in an RRSP as the US recognizes the RRSP for dividends. Funds can get a bit more complicated. Regardless, utilizing the accounts and maximizing contributions to them is the most important thing. Investors can get very nuanced on how to best utilize these accounts but the most important aspect is simply that individuals use them in the first place.

One other area that is manageable for an investor is that of tax-loss selling. In a taxable account, an investor can sell investments with a loss and use that to offset any taxable gains they may have to help mitigate any tax liability year to year. Some caveats here are that there is a 30-day period where the asset cannot be repurchased. If it is purchased within that period, it is deemed superficial and cannot be used to offset capital gains elsewhere. The main risk with this strategy is not to be penny wise and pound foolish. Small losses are unlikely to be worth “harvesting” simply because after transaction costs, missed dividends, and foregone potential returns, the odds of coming out ahead quickly get smaller. Also pay attention to the type of company you are tax-loss selling. Large blue-chip dividend payers often make more sense, as they are less likely to see a big move any given day or month. Smaller or higher-growth companies may be less appropriate to sell as something may happen, sending shares higher and leading to large opportunity costs in terms of foregone returns. One way to mitigate this risk is to tax-loss sell a single holding and purchase an ETF that has an exposure to that area/asset. While they will not move in the same way, it at least maintains the exposure in case the whole industry/asset class sees a move. One final mistake we often see when investors carry out this strategy is that they rush to do it at year-end. We prefer to do this actively throughout the year (maybe set a calendar to do it quarterly) so you are not racing against the clock, along with everyone else.

The 5i Research Model Portfolio Approach:

The model portfolios take a “before-tax” approach simply because everyone’s tax situation is different. Regardless, we view after-tax returns as being just as important (and maybe more) as before tax returns.

While it was close, we managed to summarize five keys to portfolio creation and maintenance. Whether an investor uses ETFs, mutual funds, or individual stocks, keeping these principles in mind when structuring a portfolio can go a long way to reduce risks and still allow the portfolio to contribute to your financial independence. Getting the big things right like diversification and keeping costs low sets investors up for success while giving them some room for error when they try to get the smaller details in order over time. Our model portfolios (balanced, growth and income) take all of these principles into account and allow an investor to track, shadow or modify them as they see fit.



Ryan Modesto, CFA, is Chief Executive Officer at 5i Research Inc. in Waterloo, Ontario. He can be reached at