Where should you invest this year's contribution to your registered retirement savings plan? The answer depends, in part, on what type of investor you are.
If you're a passive investor, you likely will want to use contributions to rebalance your portfolio back to target allocations. If you're an active investor, you'll likely be looking for vehicles that will give you the most bang for your buck.
Let's look at some top picks for passive and active investors. As we shall see, the emphasis falls on interest-bearing investments, which also happen to be the most suitable for a registered plan.
For passive investors Ram Balakrishnan, a passive investor who blogs under the name Canadian Capitalist, says he'll likely be adding to his bond holdings.
As he reports: "Our RRSPs hold short-term bond ETFs, REITs [real estate investment trusts]and foreign stock ETFs, so any RRSP contributions, as well as dividend or interest income, is used to bring an underweight asset class back to target. Last year, for instance, I found that the RRSP contributions were channelled to buy foreign stocks and REITs. With the markets bouncing sharply off the bottom, this year I'm finding that bonds are below target."
"Mike" of the Four Pillars blog will be rebalancing too but separately from the contribution to his registered plan. One reason "is that if your annual contributions are a small percentage of the portfolio size, then it becomes harder and harder to rebalance."
"I'm pretty sure I'm currently overweight in equities," he continues. "So I will buy some short-term bonds through the iShares Canadian Short Bond ETF [XSB]and sell one or more equity ETFs."
These two passive investors prefer short-term over long-term bonds for reasons outlined in William Bernstein's The Four Pillars of Investing . Specifically, the small increments in yields on bonds beyond the five-year maturity don't compensate enough for inflation and interest-rate risks. Also, long-term bonds have less diversification benefit because their prices tend to move more in line with stocks.
For active investors Short-term bonds also look good for active investors. This asset class should perform relatively well if trends in the economy unfold as projected by Canada's top portfolio strategist (No. 1 in Brendan Wood International's survey), CIBC World Markets Inc.'s Peter Gibson.
"There's going to be concern next year that the economy is still softer than people think," he told Bloomberg media in December. Gains in stocks will be restrained by modest growth in corporate earnings while the absence of an inflation threat will be supportive of bond prices.
However, in the second half of 2010, inflation fears are expected to flare up and cause an upward trend in interest rates. Stocks will be driven down, as will prices for long-term bonds.
Prices for short-term bonds may slip too, but by a relatively smaller amount. Moreover, their yields will rise quickly as maturities expire and the proceeds are rolled over into new short-term bonds at successively higher rates.
The iShares Canadian Short Bond ETF (XSB) is one way to own short-term bonds. Another would be a ladder of individual bonds or guaranteed investment certificates. Yet another would be a corporate-bond ETF like the Claymore 1-5 Year Laddered Corporate Bond ETF (CBO).
"Corporate bonds continue to present better value than government issues due to the incremental yield they provide and their relatively short duration, which makes their investors less susceptible to any uptick in interest rates," noted the TD Wealth Management Asset Allocation Committee in its market outlook issued in early January.
Keep diversification in mind
Whatever investment you are planning to add to your portfolio, some consideration should be given to how it fits with the rest of your holdings. Is it likely to move in the same direction as an already dominant holding, thus increasing volatility and risk? Does it leave your portfolio under-diversified or over-diversified?
"I once had a visit from a 64-year-old businessman who wanted high income and put about 75 per cent of his capital into a private mortgage fund paying 10 per cent," reports Warren MacKenzie, president and chief executive officer of Weigh House Investor Services. "We suggested that he should be more diversified."
When the 64-year-old went to redeem his units to diversify, he discovered there was a hold on redemptions. His wealth was not only undiversified but mostly illiquid. What if he had needed funds for an emergency? Or if the investment was in a registered retirement income fund where government rules require annual withdrawals?
Keep your "holistic balance sheet" in mind, too When adding new investments to a portfolio, also consider how they fit with the non-financial assets of human capital, house and family. For example, if you are an investment banker, a high exposure to stocks may not be prudent given your job is affected by the stock market.
York University professor Moshe Milevsky says: "When Professor Harry Markowitz introduced the financial world to the mathematics of diversification, he … meant all forms of capital. Your job is an investment, your house is an investment and even your spouse is an investment. Make sure your RRSP takes those bigger investments into account."