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financial compass

The Hulk, from “The Avengers“

About 10 years ago, Adrian Mastracci welcomed potential clients – a husband and wife – into his office and sat down with them to look over their investment portfolio. As he flipped through the paperwork, he suddenly felt faint.

The portfolio, which had once amounted to $1.4-million socked away in a registered retirement savings account (RRSP), was now worth about $375,000.

And this was before the 2008 crash.

"The guy was saying, 'Things go up and things go down.' I had to refrain from laughing," says Mr. Mastracci, the discretionary portfolio manager with KCM Wealth Management Inc. in Vancouver. "Meanwhile the wife was saying, 'Honey, I'm concerned.' Nobody had looked at [the portfolio] or cared about it in years."

While this is an extreme example of a portfolio suffering from neglect, many investors who take a buy-it-and-leave-it approach can find themselves with accounts that are either much riskier or more conservative than they originally intended.

In fact, it's common for a portfolio to drift and become overweight in certain sectors. Slowly but surely, that mix of, say, 50 per cent equities and 50 per cent fixed-income vehicles morphs into a 47/53 split, for example. Or perhaps your health-care stocks had a great year, while the financials took a nosedive. The best-performing stocks or exchange-traded funds (ETFs) become more heavily weighted in the portfolio, while underperforming picks make up less of the total allocation.

While it's okay to be overweight in certain sectors if you believe they still have room to grow in the coming months or years, that lessening of diversification is a risk.

So how can you tell whether your portfolio has drifted into danger territory?

The problem is, most people can't. That's because they likely didn't put much thought into their asset allocation in the first place, Mr. Mastracci says. When he asks new clients why they originally bought a certain stock, the typical answer is, "I don't know."

"Usually these portfolios are a patchwork of all kinds of stuff. They have 15, 20 or even 30 stocks – and nobody ever prunes," he says.

That's why it's important to start with the big picture and come up with a strategy. Why are you investing in the first place? To pay for retirement? Save for your kids' education? Buy a boat? Depending on whether the money is meant for vital long-term financial goals or simply to pay for a want-it-but-don't-need-it Corvette Stingray, that determines your investments and how they're allocated.

But let's say you did have a plan in place. What now?

Robyn Thompson, chartered investment manager and president of Castlemark Wealth Management Inc. in Toronto, has a system.

"Rebalancing is about bringing back the portfolio to its intended mandate. It's like a reset," she says.

To start, pull out the statements for all your holdings and calculate the value of your entire portfolio. Then look at the value of each individual holding. That way you can calculate the relative percentage weighting for each one inside the portfolio, Ms. Thompson explains.

Compare these numbers to the book value when you originally purchased them and see how much they have drifted.

Once you have an idea of where you are now, dig deeper and categorize the asset classes you hold. Are you now overweight in Google or IBM stock? Both would add more risk to a portfolio. Or do you have too much sunk in fixed income securities such as GICs and bonds?

Then drill down deeper and determine which sectors and industries your equity holdings belong to. If you're shocked to see a large percentage of your holdings are in the technology sector, for instance, it's likely time to rebalance.

Or maybe you have corporate bonds or municipal bonds that have performed well (and become overweight) over time. To rebalance the portfolio, sell off a portion from the best performers and invest that profit into lower-cost options that keep you diversified again.

Not many Canadians will ever be properly diversified, says John De Goey, vice-president and portfolio manager for Burgeonvest Bick Securities Ltd. in Toronto. The problem is home-country bias, which Canadian investors have in spades.

Although Canada represents only about 4 per cent of the world's stock market capitalization, typical Canadians do a good job loading up on Canadian stocks, either by buying them directly or indirectly via mutual funds and ETFs, he explains.

The problem with being overweight Canada has everything to do with how overweight our own stock market is. Investing in the TSX composite index nearly always means throwing money at three of our largest sectors.

"It would be fair to say that everyone – by broad international standards – is going to be overweight financials, materials and energy, just by default," Mr. De Goey maintains. "Old habits die hard. There are a lot of people who think they can diversify by sector and don't have to diversify by geography."

Even popular balanced funds sold in this country are nearly always overweight Canada, no drift required. The Tangerine Balanced Growth Portfolio, for example, holds more than 23 per cent in Canadian equity – well above that 4-per-cent magic number.

"It wins the reverse beauty contest. It's less ugly, but it's still a product that is subject to the same flaws," he says.

And here's another problem: Many investors just don't care they're overweight. Think back to the technology boom and bust in 2000 when investors around the world gleefully filled their portfolios with swelling tech stocks, even though it would have been safer to sell. Or how about the Nortel investors who held on to their massive numbers of tumbling shares for far too long?

Studies have shown that loss aversion can have dire consequences for investors who don't want to sell their underperformers for fear of making their "paper loss" the real thing.

"If you sell when it's down, it's an actual loss and you have to admit you've messed up," says Mr. De Goey. "People don't want to admit they've messed up."

Luckily, there's help for investors who prefer to put their heads in the sand and hope for the best long-term. Make a rebalancing schedule and stick to it, says Tyler Mordy, president and chief investment strategist of Toronto-based Forstrong Global Asset Management.

"The antidote to sector or style drift is to rebalance regularly," he says.

Unless your lifestyle has suddenly changed or there's been a huge correction in the market, you probably don't have to rebalance more than once a year. But it's not a bad idea to check in twice a year or even quarterly, just to be sure your portfolio is still going in the right direction.

"Tweak it every now and then if you need to do that," agrees Mr. Mastracci. "Just don't go tinkering. There has to be a reason to make a change."