Volatile times call for a portfolio tune-up

We investors are like meat in a risk sandwich.

Above us, we have increasingly twitchy stock markets that look vulnerable to a pullback of some sort. Not necessarily something 2008-ish, but jarring. It might be the debt problems in Greece and other European countries that gets the decline rolling, or simply gravity catching up with a year-long market surge.

Below us, bonds present another set of risks. Interest rates have already started to creep up and further increases will erode the price of bonds and, more importantly, bond funds.

Nothing is for sure in today's markets. The economic recovery could stall, short-circuiting the interest rate threat. Stocks could wander sideways for a while or retreat gradually. The one certainty out there is that right now is a perfect time to tune up your portfolio for the potential risks ahead. Here's a five-point plan:

1. Rebalance

The starting point of intelligent investing is to find the mix of stocks and bonds that suits your age, investing goals and risk tolerance. You adjust this mix when your needs change, not when market conditions shift.

Your portfolio changes on its own, however. The Canadian stock market is up close to 60 per cent from its March 2009 low, which suggests your stocks and funds have soared as well. Do they account for more than your target weighting for stocks in your portfolio? If yes, then sell some to get back on plan.

Lots of investors loaded up on bond mutual funds and exchange-traded funds as the stock markets plunged. Being overweight on bonds is almost as bad as placing too much emphasis on stocks. The solution: trim your bond exposure back to your target asset mix. Why shouldn't you get out of bonds if the outlook is negative? Because bonds still provide a refuge if the stock market plunges.

2. Stay short term with bonds

Bonds that mature in five years or less have the lowest returns, but they also hold up best when interest rates rise. So if you're putting new money into bonds right now, avoid the temptation to get higher yields from longer terms.

Corporate bonds hold up a little better than government bonds in a rising rate environment - which is to say they would decline less in price - while lower-quality, high-yield bonds do somewhat better still. Again, stick to the short term.

Let's be clear on the risks associated with bonds. As the economy strengthens, defaults are not the concern. Rather, it's that the price of your bonds or bond funds will decline. Individual bonds should still return your money at maturity, but bond funds could stay down in price until rates stabilize and begin to fall.

Consider guaranteed investment certificates as a replacement for bonds and bond funds if you don't like price fluctuations. Returns are very competitive if you use alternative banks or credit unions, and you can even get cashable GICs if you're willing to sacrifice returns.

3. Monitor interest rate exposure in your stock holdings

Some preferred shares have already been meandering lower in price at the prospect of rising interest rates. Also watch out for rate-sensitive stock sectors, such as utilities and financials.

If you're an income-first investor and own high-quality stocks in these sectors, then there's a strong argument for keeping the status quo. Rising rates say nothing about the ability of dividend-paying companies to keep handing cash to shareholders every quarter.

Worried about falling share prices? If you're investing for the long run and own good stocks, then price declines are immaterial. And yet, some investors are unnerved when supposedly safe preferred or utility stocks fall. If that's you, then consider trimming your exposure.

4. Take profits in risky sectors

Emerging markets and natural resource funds averaged returns of almost 60 per cent for the 12 months to March 31, while gold funds averaged 39 per cent and science and technology funds averaged 32 per cent. Sector funds offer potential for huge losses as well as huge gains, so be prepared by taking some of your profits off the table.

5. Keep cash on hand

Money market funds pay next to nothing right now (fund companies are making huge bucks off them, but that's another story), and cash balances in brokerage accounts are dead money. So find a high-interest savings account that trades like a mutual fund (start your search with Renaissance High Interest Savings Account and Altamira High-Interest CashPerformer), and keep some money handy to buy when stocks and bonds fall in price.

As bonds and dividend stocks fall, their yields rise. Taking advantage of opportunities like this is how you bite back against risk.

Stocks, bonds and risk

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