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Rebalancing helps manage investment risk

Financial advisers often harp about ensuring that your portfolio is properly diversified. But diversification is only part of the equation. The other half of the formula for protecting your wealth is rebalancing your portfolio. They go hand in hand, and one is no good without the other.

That's because the markets change every day, and a portfolio you created five years ago is probably so far out of whack by now that the protection you thought you had has turned into a potential liability.

By waiting too long, you've likely become heavily weighted in one asset class, at the expense of others, and face the prospect of getting crushed if the markets turn. That's what happened during the tech boom -- too many investors had too much exposure to technology stocks and got hammered when the market collapsed. That's why you need to revisit your portfolio regularly and rebalance it when the scales become uneven.

"Rebalancing is an important tool, but I caution clients not to get too carried away with it," says Adrian Mastracci, a fee-only planner at KCM Wealth Management Inc., in Vancouver. That's because too much of a good thing can also be hazardous to your financial health.

Pick an asset mix and stick to it
Mastracci says the first thing an investor should do is "set the asset-mix targets that are suitable." For many investors, a typical mix would be 60 percent equities, which includes income trusts, and 40 percent fixed income.

However, Julian Smith, a senior vice-president at brokerage firm Raymond James, in Toronto, notes that "you can drill down as many times as you want." He likes five asset classes: cash, fixed income, Canadian equities, U.S. equities and international equities.

Smith says the categories can be broken down even further. For example, within fixed income, investors can look at corporate bonds versus government bonds. The equity option can also break down a variety of ways, based on the size of companies, known as market capitalization, geography or industry sector.

Scott Ellison, a certified financial planner at Halifax-based Rudderham Norwood Ellison Investment Counsel, uses "four food groups" rather than five, and includes cash in the fixed income category. "It's all about setting up some type of financial plan and agreeing what the rebalancing mechanisms are going to be," he says.

More stocks means less overall risk
So how much diversification is enough? A recent study in Canadian Investment Review, by Mount Allison University professor David Copp, found that a portfolio of 50 Canadians stocks eliminates 90 percent of the risk associated with holding a single stock. That's likely too many for most investors, but take heart. The study found that a portfolio of 10 Canadian stocks reduces risk by 46 percent, compared to a portfolio holding a single stock.

The important thing is to be diversified and set a specific asset mix, because that formula sets the framework for rebalancing and maintaining the diversity safety net.

How rebalancing works
A balanced portfolio would be split about 60 percent equities and 40 percent fixed income. So, for a $100,000 portfolio, $60,000 would be in equities and $40,000 would be in fixed income.

As the portfolio ages, it will likely earn some dividends from the equity portion and interest from the fixed income. As well, the value of the individual assets will rise and fall. At some point, the value of the portfolio will shift and the equity component might grow or decline.

For example, let's say after six months, the portfolio has increased to $105,000. However, the fixed income portion has actually declined because interest rates are rising, which causes the price of bonds to decline. The fixed income component is actually worth only $36,750, while the equity component has climbed to $68,250.

Your mix is now out of whack because fixed income accounts for 35 percent of your investments and equities 65 percent. It's actually a somewhat riskier portfolio than what you started with because you have more equity exposure.

You can bring it back into line by selling 5 percent of the equities and using that money to buy more fixed income to restore the 60/40 split.

How often should you rebalance?
When it comes to rebalancing, the options are endless. There's nothing to stop an investor from rebalancing on a weekly, monthly, biannual or yearly basis. Or you can choose to do it based on percentages.

There's "no magic point," says Ellison. Mastracci suggests once or twice a year, while Smith likes to rebalance when a portfolio goes out of alignment by 5 percent or more.

It really depends on the individual, the experts say. However, there are some things to consider that deters from rebalancing too frequently.

Beware of transaction costs
Smith notes there are transaction costs that can impact a decision to rebalance. First, there are commissions that must be taken into consideration. Buying and selling shares costs money, and mutual funds might have charges for cashing out early.

Second, if the investments are held in a nonregistered account, then selling portions triggers taxes, which must be taken into consideration. If the cost of taxes and commissions are prohibitive, investors might want to limit the number of times they rebalance their portfolios.

Investors can also bring the asset allocation back into alignment by simply adding more money to the account and using those funds to purchase additional investments.

A report from Vanguard Investment Counseling and Research notes "there is no universally optimal rebalancing strategy." However, the more frequently a portfolio is rebalanced, the tighter the risk control. Less frequently balanced portfolios are subject to larger losses.

The study also found that the downside of rebalancing in a market that's trending up is a lower overall return. That's because chances are you'll sell stocks before they hit their peak. However, that's the purpose of rebalancing. It brings discipline to investing and takes the emotion out of it, says Ellison. "It's counterintuitive to buy high and sell low."

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.

-- Posted: March 20, 2006
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