"Where should I invest my RRSP contribution?"
Some people think the answer to this question requires hours of research to find top stocks or funds. But a bigger payoff can be obtained with much less effort.
You may already have an inkling of how to do this if you know what a strategic asset allocation is. Haven't heard the term? No worries: it's the mix of stocks, bonds and other assets that an investor chooses as suitable to their risk appetite.
A common asset allocation is to put 60 per cent of your portfolio in stocks and 40 per cent in bonds. But the mix can vary, with younger investors taking on more risk through stocks, and older savers dialling down the volatility by putting more of their holdings in bonds.
Studies show that your choice of asset allocation is crucial to your long-term returns. Problem is, a planned allocation has a pesky tendency to drift away from an investor's strategic plan. That's because different assets go up and down in unpredictable ways – stocks sometimes take the lead, other times it's bonds' turn to shine. A portfolio that starts out as 60 per cent stocks might wind up as 70 per cent stocks if the equity market has had a good run over the past few months.
Here is where RRSP contributions come in. They can be added to the lagging assets to help nudge the asset allocation back into line with the strategic target. This rebalancing not only keeps risk under control but can boost returns since it's a form of buying low and selling high.
"Investors first need to set an asset mix," said Tom Bradley, president of Steadyhand Investment Funds and author of the book It's Not Rocket Science: Plain English Advice for Managing Your Investments. "Then the mind-numbing decision of what to do at the RRSP deadline will be an easy one – allocate your contribution in line with your long-term asset mix."
Consider a woman in her fifties who sets up her portfolio with 50 per cent in stocks and 50 per cent in bonds. The stock market then goes down, bringing the mix to 40 per cent stocks and 60 per cent bonds. According to her asset allocation strategy, her portfolio is now playing it too safe: she should use her RRSP contribution to buy stocks and bring the allocation closer to her target of 50 per cent stocks and 50 per cent bonds.
You can rebalance not just at the level of stocks and bonds but within sub-categories. Stocks, for example, can be grouped into industries, regions, and so on. Even if your stock-bond mix hasn't budged, you might want to rebalance by putting RRSP contributions into lagging funds or underperforming stocks.
Just make sure to consider the big picture – both your RRSP and your non-RRSP accounts.
RRSP investors can trip up by thinking all the assets in an RRSP belong to them. Part represents taxes that will eventually by payable to the government, writes York University professor Moshe Milevsky in his book Your Money Questions. If your tax rate in retirement is 32 per cent, you really own just 68 per cent of your RRSP.
This can create a problem when a retirement portfolio is spread over RRSP and non-registered accounts. Say a man has $50,000 of bonds in an RRSP and $50,000 of stocks outside. The stocks appreciate to $60,000 while the bonds tread water at $50,000. He is thinking about adding $10,000 to his RRSP to rebalance to a 50-50 portfolio.
This won't work. Of the $50,000 in bonds in his RRSP, he really owns only $34,000, assuming a tax rate of 32 per cent. To truly balance his portfolio on an after-tax basis he would have to contribute $38,250 to his RRSP!
Using RRSP contributions to rebalance an RRSP portfolio is a fairly straightforward and easy way to pump up risk-adjusted returns. But if part of a retirement portfolio is held outside the RRSP, extra care is required with asset allocations and rebalancing.