At least once a year we encourage investors to rebalance their portfolios. This review should assess the portfolio from three important areas – asset allocation, diversification, and concentration.
Compare your current portfolio to the investment policy statement (IPS). If any of these important areas are misaligned then January is often an excellent month to rebalance the portfolio.
During the past year most equity investments performed very well. The process of rebalancing involves investors selling a portion of their equity investments and allocating the proceeds to the other asset classes such as fixed income and/or cash equivalents. Additional deposits to investment accounts and/or contributions to an RRSP can be directed to the underweighted asset class. This rebalancing assists people in having the discipline to stick with the asset allocation percentages outlined within the IPS.
Within each asset class investors have the ability to diversify their investments. Using equities as an example, an investor may achieve equity exposure by owning the following: common shares, preferred shares, income trusts, mutual funds, exchange traded funds, etc. The news release last October from the federal government primarily effected income trusts. Investors with different equity types were able to weather this announcement more easily then those concentrated on trusts.
Investors should also review their portfolio for other forms of diversification. The fixed income investments should be reviewed for credit quality and duration to maturity. The equity investments may be diversified by geography, type and sector.
Geography is normally broken down between Canadian, International and Global. International is normally a term used to refer to investments outside of North America. Global is a term that encompasses the entire world. Many portfolio managers and analysts have highlighted the strength of the Canadian markets over the last several years and have encouraged investors to consider moving some of those profits outside of Canada.
Investors have the opportunity to invest in different size companies, normally referred to as small, medium and large capitalized companies. Well established large cap companies are often referred to as blue chip equities. Generally small cap companies outperform large companies; however, small cap is considered riskier than blue chip. Selecting a balance and a means to obtain exposure to the different size companies should be done at the rebalancing stage.
Analyzing your portfolio by sector is also an important exercise. The following are the current weightings in the S&P/TSX Composite Index:
Some investors choose to overweight or underweight the above sectors based on their outlook for each sector. Those investors seeking opportunities in sectors such as health care and technology may explore opportunities beyond our domestic markets.
Concentration within a portfolio refers to an individual equity or sector being overweight in the portfolio. Avoiding concentration is important to reduce overall portfolio risk. A general rule of thumb we use is that no individual equity position should exceed the lower of 10 per cent of the equity portion or 5 per cent of the entire portfolio. Sticking to this discipline will ensure even the worst announcement by a corporation will not materially impact your total portfolio.
Some of the most successful investors over time have held onto good companies for the long term resulting in an overweight position within the portfolio. A portfolio concentrated in fewer positions may perform well but more risk is assumed. It is important for investors to understand their degree of concentration within their portfolio and entire financial picture.
January is generally a good month to rebalance portfolios, especially if the investments are non-registered. Individuals who realize gains in January will be able to defer the tax at least one year. January has also historically been a positive month in the markets. If all of your investments are within registered plans (RRSP and RRIF) then you can effectively pick any month of the year.
The most important thing to take away is to establish the discipline to rebalance. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.