How and when to rebalance your retirement investments

Chances are good that you've heard you should rebalance your investments from time to time. Chances are also good that you may not know whether that has ever been done to your portfolio, whether you have to do this yourself, and how the heck you do it.

At its heart, rebalancing is nothing more than the process of bringing your portfolio back in line with the original asset allocation mix you'd decided on. In other words, making sure your investments continue to properly reflect your investing goals.

That's assuming you've actually decided on the mix you're aiming for in the first place.

Some do-it-yourselfers don't have a formal asset allocation plan; they just buy stuff and hope everything works out in the long run. But the experts say the asset mix decision is critical – perhaps the the most important decision an investor can make – because it's how the level of risk is controlled. Investors should decide on a mix, and rebalance it from time to time.

Rebalancing tools

Many discount brokers, banks and mutual fund companies have asset allocation tools on their websites. They ask a series of questions to arrive at an appropriate investment mix for you, given your age, years to retirement, income and risk tolerance.

These asset allocation tools will suggest investors buy a certain mix of equities, with the remainder of the money kept in fixed income and cash/money market funds. They'll often also suggest some funds or "managed solutions" the financial institution sells.

Whether you take them up on those suggestions is up to you — you can always build one of the many passive "couch potato" or "two-minute" portfolios out there using cheaper exchange-traded funds or index funds. But then you'll have to do the rebalancing yourself.

What's a good asset allocation mix?

Most advisers will ask their clients a number of questions to get a sense of their tolerance for risk and, by extension, their approppriate investment mix.

A common guideline has people substract their age from 100 to get the percentage of their portfolio that should be in equities, with the balance in fixed income. But that's highly dependent on personal circumstances.   

Why rebalance?

The financial return investments deliver and the risks they carry change over time with the ups and downs of the markets and the economy. Returning your portfolio to its target mix is designed to keep the risk profile the same.

If, for instance, you have decided that you're most comfortable with a 50/50 mix of equities and fixed income, a big run-up in the stock market could throw that target way off track. You could end up with 70 per cent of your portfolio being equities and 30 per cent in bonds — in this case, a portfolio that you might consider way too risky.

Failing to rebalance can lead some investors to sell in panic or suffer big losses when their suddenly equity-heavy portfolio starts diving during a market sell-off.  

In the course of rebalancing, you can also make a decision to adjust your asset mix away from its neutral position. If you think the market is overvalued and ripe for a fall, you could choose to cut your equity exposure below what your target calls for, for example. This is called tactical asset allocation, and there are many mutual funds that practise this — with varying degress of success. 

How to rebalance

The do-it-yourselfer has only to figure out how much of a particular asset class and which individual investments to sell to get back to the desired mix. 

Investors who use financial advisers should ask them about rebalancing at their annual reviews. They may find that rebalancing is already being done for them.

That can be tougher than it sounds. Some investors are reluctant to sell any of their winners.

If you find your investment mix has become too skewed away from your original target mix, you can sell some of your winners and plow that money into your trailing asset class. Alternatively, you could just buy enough of the trailing asset class to return your portfolio to its original target mix.

And remember that selling investments in non-registered accounts can often have tax implications, so these should be kept in mind. For tax-sheltered RRSP and RRIF accounts, obviously, this isn't an issue.

Investors who use financial advisers should ask them about rebalancing at their annual reviews. They may find that rebalancing is already being done for them.

Most balanced mutual funds — which contain a mix of equities and bonds and perhaps a bit of cash — feature periodic rebalancing. They've proven to be a popular destination for investors' money. The latest data from the Investment Funds Institute of Canada shows $336 billion invested in balanced funds — 43 per cent of the total money invested in funds.

Investors should be aware that many of these funds do have fees that eat up more than two per cent of their returns annually — an important consideration when a significant portion of the fund is invested in what are now low-yielding bonds. Investors can check the fee for their particular balanced fund — often referred to as the MER, or management expense ratio — in their fund's prospectus, or at the Fund Library or Globe Investor Funds.

Many advisers have also placed their clients in managed portfolios — often called "wrap" accounts — that are made up of other mutual funds. These "funds of funds" usually feature an automatic quarterly or semi-annual rebalancing process.

But these wrap products also have fees that are charged in addition to the fees imposed by the underlying funds they're invested in. Purchasing the underlying funds directly and having your adviser do the rebalancing is cheaper.

It's even cheaper to buy a mix of exchange-traded funds or low-cost index funds and do the rebalancing yourself. For do-it-yourselfers, some mutual funds also offer cheaper versions of their funds that strip out the adviser compensation part of the fee.

When to rebalance

Many portfolio managers have set percentage thresholds for rebalancing, rather than arbitrary time periods. So once the equity portion of the portfolio has deviated by five, 10 or 20 per cent from the original target, it would trigger a rebalancing.

Many experts suggest at least an annual review of your portfolio to see whether it would make sense to rebalance. You can rebalance more than once a year if the markets have made significant moves, but rebalancing every month is excessive.

What a regularly scheduled rebalancing can do is take some of the emotion out of buying and selling. Research in behavioural economics shows that investors can often be their own worst enemies. Some people claim that rebalancing produces better returns, because people end up selling the out-performing asset class and buying the under-performing asset class.

In reality, the verdict isn't as clear cut. Certainly there are occasions when rebalancing has resulted in financial gains. But several studies have shown there are times when it has reduced returns as well.

The goal is really to manage risk and make sure your investment portfolio reflects your investing goals.