Psst! Wanna hear a secret? Investment success doesn’t come from picking great stocks and mutual funds, nor does it come from knowing when to get in and out of the market or when a company is about to grab the brass ring or fall on its face.
Nope, investment success lies in the fairly simply process of deciding how to spread your investment eggs among various baskets (asset allocation or AA) and sticking to that decision until there is good reason to change (rebalancing).
Rob Carrick detailed some examples of AA for various ages in his post “Adapting to Risk with Age.”
Once you have decided how much you want to invest in the three main asset classes (cash, bonds and equities), the real trick to making asset allocation work is rebalancing. Wealth managers estimate that anywhere from 60 per cent to as much as 80 percent of a portfolio’s return comes from these two tasks.
Rebalancing involves looking at your portfolio from time to time and making sure it stays close to your original allocations. For example, say you have chosen this AA for your RRSP:
- 10% Cash (such as a GIC)
- 40% Bonds
- 25% Canadian Equity
- 25% U.S. Equity
Then, let’s say the market goes on a tear as it did in the beginning of 2011. As a result, in April your asset allocation might have looked like this:
- 8% Cash
- 32% Bonds
- 30% Canadian Equity *
- 30% U.S. Equity *
* The proportions of your cash and bond decreased because the equities increased.
The percentages show that your equity portion has jumped to 60 percent of your overall portfolio from 50 percent. Rebalancing is the process of bringing a portfolio back to its original asset allocation when the proportions get out of whack.
If you are contributing money regularly, you don’t need to sell anything; you simply need to divert new deposits to the fixed income part of your portfolio until the proportions return more or less to the original allocation. You can also use cash in the account from interest and dividend income.
Rebalancing means that you need to take a gander at your investment statement and read the section that lays out your asset allocation. If you can’t find it, contact your adviser or, if you are a DIYer with an account at a bank discount brokerage, call the helpline or go into your branch and talk to one of the licensed advisers.
Don’t get crazy and rebalance with every hiccup of the market. Research shows that micromanaging actually reduces a portfolio’s return and, in any event, you’ll waste money on unnecessary fees. Once or, at most, twice a year is usually sufficient over time.
Once you get the hang of rebalancing, you will have the foundation of a strong portfolio that is more resilient during turbulent times.
Next blog: Does rebalancing mean that buying and holding is wrong?