It’s the beginning of a new year and hopefully 2014 will be better than 2013, both for you and your portfolio.
This is not to say that 2013 was a bad year to be in the markets. In fact, it was probably one of the best years in recent memory, thanks in part to the great rotation of cash into bonds and stocks.
As the “good times” in the financial asset markets return we all need to keep locked away in our financial memories the lessons of the 2008-09 financial crash which, at least on paper, wiped out billions, perhaps trillions, of dollars in wealth.
It is very tempting for us to look at markets or sectors of the markets that have vastly outperformed Canadian equity markets and think, “Hey, I want a piece of the action!”
Herein lies the challenge to our individual and collective financial futures.
We tend to focus on the winners, ignoring the often-unseen potential of individuals, investments, or for that matter sports teams, that are currently not showing a hint of performance.
Witness the Toronto Maple Leafs a perennial loser in the race for Lord Stanley’s Cup, but reversion to the mean tells us that eventually losers become winners and those now winning will revert to a more normal pattern of winning and losing.
The same is true of investment assets.
Those securities that have been high flyers will eventually produce more normal returns.
So buying stocks, bonds, ETFs or mutual funds that have performed well in the past may not be the best strategy.
While I admit that my example of the Leafs might not be a popular or even good example of reversion to the mean, the 1999-2000 tech bubble, and its effects on stock market performance, is an excellent example of reversion to the mean.
So how should one approach investing his or her 2013 registered retirement savings plan (RRSP) or tax-free savings account (TFSA) contributions?
First, start by shunning the urge to invest in that which was hot last year. This can be done easily by simply choosing an appropriate long-term weighting between cash, bonds and stocks in your investment accounts, and then re-balancing your portfolio at least annually.
An example should help us to better understand how re-balancing works. Let’s assume that you have accumulated $10,000 in a TFSA, and that you want to maintain over the long term an asset allocation of 50 per cent bonds and 50 per cent stock.
If your bond investments rose by five per cent and your stock investments by 20 per cent, excluding interest or dividend payments, your TFSA would now be valued at $11,250 — growth of 12.5 per cent.
Most investors would certainly think that this was a great return on investment. However, the problem is that now your asset allocation is out of alignment with your long-term objective of 50 per cent stocks and 50 per cent bonds. Your TFSA is now weighted 47 per cent bonds and 53 per cent stocks.
This might not seem to be a serious problem over a period of a year or two, but unchecked over the long term, growth in a single asset class can lead to very substantial over-weightings in an investment account. This could result in potentially higher losses if the over-weighted asset class drops in value.
One solution is to regularly rebalance your portfolio, perhaps annually. Re-balancing is the process of selling a proportion of investments that have risen in value so that your investment portfolio is re-balanced to its proper long-term asset allocation.
In our example, we would need to re-balance the TFSA so that $5,625 was held in bonds and $5,625 was invested in equities. To re-balance, we would sell $375 of equity and invest the proceeds in bonds.
Yes, I know what you are thinking. “What, you want me to sell winners in my TFSA?”
The answer is yes.
Winners can eventually become losers through reversion to the mean. And the goal of rational investors is to maximize wealth over the long term while minimizing risk.
So resist the temptation to keep last year’s winners, and rebalance your portfolio.
Re-balancing has two other important benefits.
First, it forces you and your account manager to think about new investments that should added and ask the critical question, “Does the current asset weighting make sense for my circumstances?” Second, by cashing in current winners and investing in potential future winners, rebalancing can reduce your average cost through effective dollar cost averaging.
So take hold of your financial future in the next few weeks. A great way to start is to ask, “Do I need to re-balance my investment mix?”
Remember you are in control of your financial future.
Easy Money is written by Patrick O’Meara, a former instructor at Red Deer College’s Donald School of Business, who is now chair of finance and accounting programs at Centennial College in Toronto. He can be reached at email@example.com.