This 5-point annual review can reveal weak spots
Your investment portfolio is the cornerstone of your wealth accumulation plan over the long term. Whether your investments are in non-registered trading accounts or in tax-sheltered plans like RRSPs and TFSAs, you rely on a sustainable rate of portfolio growth from both capital gains and income to achieve your financial goals. But portfolios don’t look after themselves. Markets are volatile and can go into steep declines, as happened through 2022. Like bull markets, bear markets not only affect overall portfolio valuation, but can also distort your asset allocations, and thus your risk profile, shifting it considerably from what you originally had in mind. An annual portfolio review can show if your portfolio has gone off the rails and where attention is needed.
To help you get started, here’s a basic five-point annual review.
1. Check asset allocations
Assets fall into three key groups: safety, income, and growth. The weight that each group commands in your portfolio largely determines the return you can expect and the risk that you’re accepting over a given time. If that allocation is skewed by extraordinary gains or losses in one class or another over the year, your risk profile will change. For example, steep losses in equities may have underweighted that asset class and unduly skewed the weighting of your fixed-income or cash holdings. But because cash and fixed-income are considered more defensive than equity, that means your overall risk profile has become more defensive, perhaps much more than you wish.
Through 2022, both stocks and bonds lost ground, as central banks tightened monetary policy through an aggressive series of interest rate hikes in an effort to slow down the economy and cool inflation. In this worst of all worlds, there was really no good option for investors other than attempting to preserve their portfolio value by switching to mostly cash holdings (that is, risk-free money market funds and the like).
That probably worked for a while, provided you made the switch early enough in the developing bear market to cushion against growing losses. But now, with markets bottomed out and starting to build a base for the next bull cycle, you’re left with an ultra-defensive portfolio, not earning much income and no potential for capital gains at all. In other words, you have no diversification.
It’s important therefore to look at your asset allocation at least once a year, and preferably twice a year during periods of higher volatility, to calculate your relative equity and fixed-income allocations. Then rebalance back to your original objectives. You may need cut your cash allocation back to your original normal, buy back into equity and fixed-income to restore your original target allocations.
Rebalancing is an important tool you can use to mitigate risk and is a key component of the investing process.
2. Diversification matters
It doesn’t make a lot of sense to hold only cash or one bond and one stock. An annual portfolio review will reveal whether the individual asset classes in your overall portfolio contain a sufficient number of diversified securities to provide good diversification. For example, in the fixed-income portion of your portfolio, you’d hold a mix of federal, provincial, and corporate bonds. The simplest way to do this is by holding a number of fixed-income investment funds that can be further diversified by yield and duration. And in equities, you’d diversify by sector, by region, by capitalization, and so on, to achieve your desired risk level.
3. Harmonize securities
With proper research, your individual stock and bond holdings work in harmony to achieve a specific objective, say a minimum dividend yield or a specific target price gain or a specified yield to maturity. When that target has been achieved, the position is usually analyzed to determine whether a switch or change within the portfolio is needed. Your portfolio review will show whether full-year performance targets have been met, and whether trims, sales, or new purchases are needed.
4. Review investment funds
Mutual funds and ETFs are cost-effective ways to diversify across broad market segments. On the other hand, they are also easy to forget about. So be sure to review your funds’ performance over the past year and compare it with your investment rationale. Have there been changes in fund management or mandate (in the case of mutual funds) or to index methodology, liquidity, or ownership (in the case of ETFs)? Investment funds are frequently closed, merged, and renamed. Make sure such funds still deliver what you expect. If not, consider switching.
5. Beware of tax consequences
Securities transactions, especially when rebalancing portfolios, may attract unintended tax consequences or other unwanted effects. Use any tax losses you incurred when selling losing positions last year to offset any gains you might have made (for example, in energy stocks and funds). Remember, your objective is not to remake your portfolio but to restore it to a state where it continues to meet your time horizon, risk tolerance, and return objectives. If your portfolio has outgrown your ability or desire to manage it, consider consulting a qualified independent financial planner to help you work through the review process.