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RRSP CHECKUP
Is your portfolio out of whack?
Rebalance of portfolio might mean parting with winning stocks
Rising stocks have probably left your investment mix unbalanced. It's time to sell some winners and protect yourself from a market correction
ROB CARRICK
After three rip-snorting years for the stock market, there's just one thing to do with your Canadian equity funds and stocks.
Sell 'em down, baby. Not all the way to zero, but certainly down to the level specified in the blueprint that you or your investment adviser used to construct your portfolio.
One of the more subtle pitfalls in investing is falling in love with your winners and not judiciously selling or reducing your holdings when they get out of control. With registered retirement savings plan season at hand, now is a perfect time to rebalance your portfolio.
First, let's look at your motivation for doing two things that are completely counter-intuitive: selling what's working in your portfolio and putting the money into things that aren't working. One benefit is that it gets you to do something that investors too often fail at - selling high and buying low.
But the more important reason is to maintain the diversification plan that your portfolio was built on, so that you are not excessively exposed to a correction in the Canadian market or excessively underexposed to a rally in markets outside Canada.
The obvious rejoinder here is that the Canadian market appears unstoppable, and so does the Canadian dollar. If domestic stocks are strong and our rising currency erodes returns from abroad, then why mess with success?
The reason is that there are reasons to be wary of over-exposure to the Canadian market right now. While it's true that the S&P/TSX composite index hit a five-year high in early 2006, there's no getting around the fact that stock markets don't very often rally for four straight years. Meanwhile, there's talk that stock markets in the Far East could be in for a big year, like Japan had last year.
Anyway, portfolio rebalancing isn't really about guessing where the next hot market will be. It's really an exercise based on the idea that your portfolio should be diversified in a way that prevents you from ever having to worry about what's hot and what's not.
Now for a practical guide to portfolio rebalancing.
To start, go back to your original portfolio blueprint (the jargon term here is asset allocation model), which has laid out the percentages of your holdings that should go into bonds, Canadian stocks, global and U.S. stocks, income trusts and such. These allocations are based on such factors as age, risk tolerance and the amount of investment income you need to retire, and they should only be altered when these variables change.
Next, take a look at the areas of your portfolio that are most likely to be out of whack in early 2006. The obvious place to start is your Canadian equity funds and stocks.
Some of the most widely held Canadian equity funds have delivered a compound average annual return over the past three years of close to 20 per cent, which would have turned a $10,000 investment into as much as $17,280.
It's easy to see how your Canadian holdings can gallop ahead of everything else when you consider that the average Canadian bond fund has returned about 5.2 per cent annually in the past three years, the average global equity fund made 9.1 per cent per cent and the average U.S. equity fund made 4.9 per cent.
Other sectors that may have grown too much for their own good include Canadian dividend funds, income trust funds, resource funds and possibly precious metal funds. Dividend funds are a comparatively benign asset class - if you're going to be overexposed to something, make it this.
Trusts are more worrisome, not because of any imminent dangers but because the people who own them may not be mentally prepared for a setback in the sector. This perception is based on the frenzied reaction of investors when trusts declined on speculation last fall that the federal government was going to tax them.
While there was justifiable anger at Ottawa's handling of the trust file, there was also much shock and dismay at the sight of the ever-buoyant trust sector hitting the rocks. Plainly, lots of people haven't grasped the idea that trusts are stocks, which means they can and will slump at some point.
There's an urgent need to pare back holdings in anything with heavy exposure to energy stocks, be it a natural resources fund or an equity fund that has bet heavily on this top-performing sector. If you own a hot small-capitalization equity fund, be sure to check its exposure to junior oil companies.
Resource funds should account for only about 5 to 10 per cent of a portfolio, but they're quite likely to be a much larger presence thanks to gains that in many cases have been in the area of 31 per cent annually over the past three years.
A more speculative investor might choose to take profits in a resource fund and move on to the hot sector du jour. Generally, though, the point of rebalancing is to sell down your winners to a point where they're back in line with their target weighting in your portfolio. If your Canadian equity holdings now equal 50 per cent of your $100,000 portfolio but your blueprint calls for 35 per cent, it's time to sell $15,000 in shares or fund units.
This leads to the question of where to put the money.
Given the ghastly returns from global and U.S. equity funds in the past few years, these categories are probably under represented in your portfolio. Further increases in the Canadian dollar may work against you, but if the currency slips at all in 2006 it will pump up your returns a bit.
Now is an especially good time to rebalance your portfolio because the markets are still strong and you'll be able to sell down your winners at premium prices.
Wait too long, though, and falling markets will rebalance your portfolio the hard way.
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