A disciplined investment process begins with determining the asset mix — the portions you have in cash, fixed income and equities — that is right for you.
Fixed income includes guaranteed investment certificates, term deposits, bonds, bond-exchange-traded funds, debentures and preferred shares. Equities are what many would refer to as the stock market.
Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information today. This is the reason your investment strategy is not just about the markets.
When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years.
Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors, this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.
Interest rate changes and market movement results in fluctuations in your asset mix from the day you begin investing.
To illustrate, we will use “Thomas and Heather Bennett,” who invested in a portfolio with no cash, 40 per cent fixed income and 60 per cent equities. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. This means the Bennetts’ portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs.
Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter-intuitive to sell an asset class that is doing well or buy one that is not. However, that is precisely what is required if the fundamental principle of “buy low sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.
Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counter-intuitive. When markets are down, human nature would have us liquidate rather than buy low, but a disciplined rebalancing process can prevail in the long run.
Although at times the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit of doing so can be significant over the long run with compounding returns. It is important to talk to your adviser initially to determine your optimal asset mix you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have an IPS, your adviser can establish a customized portfolio.
Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review your IPS to ensure you are comfortable with the mix. Changes in market conditions and interest-rate outlook are factors to discuss with your adviser when revising the mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.
The asset mix is the macro decision within the IPS and is the first step in rebalancing.
Step 2 is looking at micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income and mix between small, medium, and large capitalized firms.
We noted the Bennetts initially wanted 60 per cent in equities and started with total investments of $1 million. The equity portion of $600,000 was divided into 30 companies with $20,000 invested in each. Due to market movement over the last year, the Bennetts now have a portfolio valued at $1,080,000: 63 per cent in equities and 37 per cent in fixed income.
Step 1 for the Bennetts rebalancing of the asset mix would result in selling three percent of equities, or $32,400, and allocating this to fixed income.
Step 2 in rebalancing highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step 2 resulted in the Bennetts selling a portion of the star performers in the overweight sector.
When significant deposits and withdrawals are made, it is an ideal time to look at both macro and micro rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals.
Kevin Greenard CA FMA CFP CIM is an Associate Portfolio Manager with The Greenard Group at ScotiaMcLeod in Victoria. His column appears every second week. Call 250-389-2138.
