Is it time to rebalance your portfolio?
With North American stock market indices hitting record highs, you may be wondering if you should be taking any action on your investments. The answer is likely yes! After such strong recent gains in equities (growth assets), your portfolio may look quite lopsided. Time to rebalance!
In this blog I am going to highlight the process we use to establish your target asset allocation and to organize and maintain proper diversification in your portfolio.
When you receive your portfolio summary for June 30, you probably will see a greater value on the bottom line than you did at the end of the last quarter. The investments in your portfolio that contributed most to that increase, however, may not be the same ones that outperformed last quarter or last year. That’s because a well-constructed portfolio is comprised of different classes of assets and each of these classes will outperform (and underperform) at different times in response to different conditions in the business cycle.
When you initially established your investment plan, you did so as part of a larger planning process. Your strategy probably called for a specific rate of return in order to fulfill “the grand vision”. Assessment of your risk tolerance using the FinaMetrica questionnaire provided a preferred mix of defensive and growth assets. Based on this, in order to achieve your desired rate of return – with an acceptable amount of risk, we carefully constructed an asset allocation plan.
The following chart illustrates how your risk tolerance score from the FinaMetrica questionnaire helps to establish parameters for your portfolio. In the example below, a risk score of less than 51 means that a portfolio with 70% growth assets would be too risky for you; you would not be comfortable enough with the risk to stick to the investment plan, even if you believed the long-term gain would be greater. On the other hand, a risk score of greater than 78 would suggest that you would be agitated about missing out on the potential for greater growth. The comfort zone for an investor with a 70% allocation to growth assets would be a risk score in the range of 57 to 69, or could be stretched to the range of 51 to 78.
The starting point (most general view) of your asset mix is based on the desired allocation to growth assets versus defensive assets. Continuing with the above example, let’s assume that the objective for your portfolio is growth and that you are comfortable with 70% in growth assets (equities) and you want 30% in defensive assets (cash and fixed income). Next to performance, it is this split between growth and defensive assets that many of our clients focus on. Because we use professionally managed portfolios (mainly mutual funds), the asset mix at all levels is dynamic, depending on the trading activities of the portfolio managers. However, in this case, when the mix is more than a few % points above or below the 70% growth, it’s a signal that we need to rebalance. Rebalancing is simply the process of realigning your portfolio holdings with your target asset allocation.
When you examine the returns of the investment funds listed in the following table, you see some big one-year numbers compared to the long-term averages. This suggests that the 30% defensive component of your portfolio may have been overwhelmed by the recent galloping growth of the equities. To manage the risk, without looking any further into your investment holdings, you can see that it’s likely time to rebalance your portfolio. (The table below includes the investment funds in terms of most dollars invested for clients of Fraser & Partners.)
As you drill deeper into your portfolio, the next layer for rebalancing requires analysis of the allocation within “defensive” and “growth”.
“Defensive” is defined in terms of the allocation to cash and the allocation to fixed income (bonds or other interest-generating investments).
“Growth” is defined in terms of allocation to equities with different characteristics. Rather than thinking in terms of geography, we have started to use the following groupings when building and rebalancing portfolios. These groupings are more useful in our increasingly interdependent global economy:
- large cap equities (representing mutual funds that invest in large Canadian and US companies, typically dividend paying);
- small/mid cap equities (representing mutual funds that invest in small to medium sized Canadian, US, or global companies);
- global/international all cap equities (representing mutual funds that invest in companies that span the globe, often based on the portfolio manager’s best ideas, or a global theme or other specific approach to selection of investments, no restriction on size or location of the company that can be owned);
- focused equity (representing mutual funds that invest in companies in real estate, or in a specific country or industrial sector, or other narrow focus).
The graphic below shows the framework that we are applying to determine the allocation into each broad asset class. It is at this level that some of the most important decisions are made relative to your long-term investment success.
The final step, to which clients and advisors often devote the most time, is the selection of the individual portfolio managers and the specific investment funds. This is the most fun but also challenging. At this level, working within the framework outlined above, we draw on the technical analysis provided by SIA Charts to identify the managers and investment funds which are demonstrating favourable relative strength. By using a systematic approach and being very disciplined, we can help you achieve the investment results that you need to live your Life Aligned™.
If you haven’t made any changes in your portfolio lately, unless you are investing primarily in balanced funds, a portfolio review is definitely in order and some rebalancing is likely required. I encourage you to get in touch with your advisor this summer, earlier rather than later, to review and take the action that may be indicated.
Have a great summer!
The information in this commentary is for informational purposes only and not meant to be personalized investment advice. The content has been prepared by Jan Fraser, Life Aligned Investing of Aligned Capital Partners Inc. (ACPI) from sources believed to be accurate. The opinions expressed are those of the author and do not necessarily represent those of ACPI.