Setting up the initial asset allocation for your investment portfolio is fairly straightforward. The challenge is knowing how and when to rebalance your portfolio.
Let’s say you’re an index investor like me and use one of the Canadian Couch Potato’s model portfolios – TD’s e-Series funds. An initial investment of $50,000 might have a target asset allocation that looks something like this:
|Fund||Value $||Allocation %||Change %|
|Canadian Bond Index||12,500||25||—|
The key to maintaining this target asset allocation is to periodically rebalance your portfolio. Why? Because your well-constructed portfolio will quickly get out of alignment as you add new money to your investments and as individual funds start to fluctuate with the movements of the market.
Indeed, different asset classes produce different returns over time, so naturally your portfolio’s asset allocation changes. At the end of one year, it wouldn’t be surprising to see your nice, clean four-fund portfolio look more like this:
|Fund||Value $||Allocation %||Change %|
|Canadian Bond Index||12,725||23.4||+1.8|
Do you see how each of the funds has drifted away from its initial asset allocation? Now you need a rebalancing strategy to get your portfolio back into alignment.
Rebalance your portfolio by date or by threshold?
Some investors like to rebalance according to a calendar: making monthly, quarterly, or annual adjustments. Other investors prefer to rebalance whenever an investment exceeds (or drops below) a specific threshold. In our example, that could mean when one of the funds dips below 20 percent, or rises above 30 percent of the portfolio’s overall asset allocation.
Don’t overdo it. There is no optimal frequency or threshold when selecting a rebalancing strategy. However, you can’t reasonably expect to keep your portfolio in exact alignment with your target asset allocation at all times. Rebalance your portfolio too often and your costs increase (commissions, taxes, time) without any of the corresponding benefits.
According to research by Vanguard, annual or semi-annual monitoring with rebalancing at 5 percent thresholds is likely to produce a reasonable balance between controlling risk and minimizing costs for most investors.
Rebalance by adding new money
One other consideration is when you’re adding new money to your portfolio on a regular basis. For me, since I’m in the accumulation phase and investing regularly, I simply add new money to the fund that’s lagging behind its target asset allocation.
For instance, our kids’ RESP money is invested in three TD e-Series funds. Each month I contribute $416.66 into the RESP portfolio and then I need to decide how to allocate it – which fund gets the money?
My target asset allocation is to have one-third in each of the Canadian, U.S., and International index funds. As you can see, I’ve done a really good job keeping this portfolio’s asset allocation in-line. How? I always add new money to the fund that’s lagging behind in market value. So my next $416.66 contribution will likely go into the International index fund.
It’s interesting to note that the U.S. index fund has the lowest book value and least number of units held. I haven’t had to add much new money to this fund because the U.S. market has been on fire; increasing 40 percent since I’ve held it, versus 18 and 13 percent respectively for the International and Canadian index funds.
One big household investment portfolio
Wouldn’t all this asset allocation business be easier if we only had one investment portfolio to manage? Unfortunately, many of us are dealing with multiple accounts, from RRSPs, to TFSAs, and even non-registered accounts. Some also have locked-in retirement accounts from previous jobs with investments that need to be managed.
The best advice with respect to asset allocation across multiple investment accounts is to treat your accounts as one big household portfolio. That’s easier said than done if you’ve got multiple accounts held at various banks and investment firms. The objective, though, is to not have to duplicate the same portfolio across multiple accounts.
My investment accounts are limited to my RRSP and TFSA, and I use a two-ETF portfolio, which makes asset allocation super simple to manage. My target asset allocation is 20-25 percent Canadian equities and 75-80 percent International equities.
Combined, I have approximately $170,000 invested in my RRSP and TFSA accounts. My RRSP is substantially larger than my TFSA at this point, but I’m adding new money to my TFSA at a higher and more frequent rate. I hold mostly International equities in my RRSP and Canadian equities in my TFSA.
|Fund||Value $||Allocation %||Account|
|VXC (All World ex Canada)||130,900||77.0||RRSP|
New TFSA contributions of course go into VCN while any RRSP contributions go into VXC. At some point soon Canadian equities will start to make up more than 25 percent of my portfolio and so I’ll be forced to sell some units of VCN in my RRSP and purchase more units of VXC to bring my target asset allocation back into alignment.
Your original target asset allocation is the most important decision when it comes to building your portfolio. Over time, as your investments yield different returns, your portfolio drifts away from that initial target, exposing it to risks that might not be compatible with your goals.
Rebalancing your portfolio reduces that risk exposure and increases the likelihood of achieving your desired long-term investment returns. The other benefit of a rebalancing strategy is that it forces you to buy low (i.e. the lagging fund) and sell high (or at least avoid buying as much of the high-performing fund).
Do you have a question about rebalancing your portfolio? Ask away in the comments below: