Why this is not a great time to rebalance your investments

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The headlines paint a gloomy picture of the Canadian economy these days. We aren't officially in recession (yet), but oil prices have fallen steeply, the loonie is suffering and the stock market is struggling.

With market volatility and a stagnant economic outlook, is it a good time to adjust your portfolio?

It's human nature for investors to react to fear-inducing headlines, says Darren Coleman, senior vice-president and portfolio manager at Raymond James Ltd. in Toronto. Pointing to the financial crisis of 2008-09, however, he says the best move investors could have made then was to stick with their investment plans and hold steady.

"One of the hardest things for investors to do is to not change things," Mr. Coleman says. "We try to advocate to people to have patience. When you look at 2008, everybody is terrified of that happening again. The reality was, if you didn't need to take money out of your portfolio substantially, 18 or 24 months later, you were back to where you started.

"You could have gotten through it," Mr. Coleman says. "Doing nothing was actually the best strategy. But people are not very good at doing nothing."

One of the most important things financial advisers do, he says, is to help investors become better investors. Consider a report by Dalbar Inc., a financial-services research firm. Its annual Quantitative Analysis of Investor Behavior report measures the effects of investors' buy-and-sell decisions as they switch into and out of various mutual funds over time.

According to the 2015 report, the U.S. S&P 500 returned an average of 9.85 per cent per year from 1994 to 2014, but the average investor in U.S. equity mutual funds realized an average annual return of only 5.19 per cent during that same period.

So investors underperformed their own investments by 4.66 per cent, almost entirely due to poor investor behaviour, the report indicates.

"We never want to be reacting to news of the moment," Mr. Coleman says. "There is value in something traditional, in looking longer-term and trying to find ideas and themes that are enduring."

People should not stray from their financial plans during volatile times, says fee-only financial adviser Ngoc Day, with Vancouver's Macdonald, Shymko & Co. Ltd.

"From our perspective, rebalancing should not happen in response to fear," Ms. Day says. "Often, if the market does a bit of topsy-turvy tumbling, people suddenly say, 'I better sell my stocks and buy something safe.'"

Diversification is vital to weathering the economic storm. Investors should set a target for how much of their portfolios should be in equities and how much in safer, fixed-interest vehicles. Then they should stick to that plan.

"If you're willing to go into the equity market, that's the nature of the beast – it goes up and it goes down. If people start buying in without a target of how much equity they should have … lured by high yield, they can end up overexposed to the equity market when they don't have the emotional fortitude or the financial capability to manage that exposure," Ms. Day says.

"In our practice, we always talk about having a target ahead of time so that you never feel burned."

Geographic diversification is important, too. Investors may feel most comfortable with familiar, Canadian names, but Canada makes up only a small percentage of the global capital market, about 3 to 4 per cent, Ms. Day says. Being concentrated in one geographic region can bring danger.

If the market takes a hit, their portfolio will also take a substantial hit. "But if they're diversified into other geographical areas, they wouldn't experience as much of a loss, and would experience possibly greater potential return when recovery happens in other regions," Ms. Day says.

More challenging to many investors is our low-interest-rate world and the changing and challenging role of bonds in a portfolio. Because we're at an interest-rate cycle that hasn't been experienced for several decades, Mr. Coleman says he fears that "psychologically, investors are approaching retirement or are in retirement today armed with exactly the wrong paradigm for how to invest."

Today's retirees saw interest rates plunge from 18 or 20 per cent to 2 per cent, and in that environment, most bonds have made money.

"We've taken it as a given for this whole generation of retirees and post-retirees that bonds are safe – 'bonds always made money for me' – and that's a problem, because that isn't true if interest rates reverse. If interest rates go from 2 to 8 per cent, all bonds will lose money. People aren't prepared for that reality."

Older investors often have expectations of returns based on what seemed reasonable when they were younger. Someone who is 63 today may remember having guaranteed investment certificates that paid 8 to 12 per cent.

Those perceptions don't align with the low-interest-rate world, Mr. Coleman says. Most people think they should hold more bonds as they age because they provide income and stability.

"Well, unfortunately, when you do the math, can you live on 70 per cent of your portfolio earning 1 or 2 per cent? And if interest rates go up over the balance of your life, you're going to lose money on that," he says. "You won't be getting 1 or 2 per cent. You will be getting a negative."

If people want income, they should look at high quality, dividend-paying companies from around the world, he says.

People need a mind shift when it comes to analyzing their portfolio, too, Mr. Coleman suggests. Instead of worrying about how much their funds go up or down on a monthly basis, they should think about how much income they can generate over time. He compares it to a dairy farmer: Instead of focusing on how much the cow is worth, focus on how much milk it can generate.

"Buy wonderful businesses," he says. "Treat them as if you were an owner, and benefit from being an owner. It's a very Warren Buffett style of investing. It's very dull. I use farming analogies because I think investing should be as exciting as farming."