Review your portfolio before jumping in
The Dow Jones Industrial Average is reaching all-time record highs. So is the S&P 500 Composite Index – amidst a pandemic and a recession, no less. And smaller investors are jumping on the bandwagon. Should you join the fun?
More money flows into equity mutual funds during market upswings, and that’s a reliable indicator of renewed interest in stocks by smaller investors, who typically are late to the party. The Investment Funds Institute of Canada (IFIC) reports that in June, investors purchased $245 million in equity mutual funds, while they redeemed $87 million in July. In total, equity fund assets rose to $522.8 billion in July, up from $507.9 billion in June.
The temptation to sell all the bonds and flip over to stocks must now seem overwhelming to many novice investors. If the money bandwagon is rolling, shouldn’t you be on it? Before you pull the trigger, though, take a deep breath, step back from the daily noise of the news headlines and take a close, hard look at your overall portfolio.
Stick to your plan
The key problem, always, is that no one knows how long a market rally will last. The current one has been underway since market lows in mid-March, recovering losses suffered during the sharp market meltdown at the onset of the pandemic lockdown. Fear and greed are the basic emotions that drive the market, and right now, greed is ascendant as near-zero interest rates make the return on equities seem more attractive than on bonds. But emotion makes for bad investment decisions. If you have made a well-considered asset allocation, made solid individual investment choices, and have done your research – whether fundamental, technical, or quantitative – and your investment objectives remain intact, then curb your enthusiasm a bit. Do a quick portfolio review to determine whether you in fact need to up your equity allocation.
A portfolio review not only tells you how your portfolio has performed against your benchmark, but whether it’s time to make changes to your holdings. You would make changes to your portfolio if some investments have done exceptionally well or have not met expectations. In either case, your asset weighting in that sector beyond may have tilted beyond your optimal target level, and distorted the risk profile of your portfolio beyond what you intended.
To conduct a portfolio review, at a minimum you need to look at four key areas.
- How are your assets allocated? 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 gains in equities may have overweighted that asset class, making your portfolio more aggressive, and unduly raising the overall risk in your portfolio.
- Are you diversified? Diversification is at the heart of risk mitigation. It doesn’t make a lot of sense to hold only one bond and one stock. Ensure individual asset classes contain a sufficient number of diversified individual securities to provide good diversification. For example, in equities, you’d diversify by sector, by region, by capitalization, and so on, to achieve your desired risk level. In fixed-income, you’d hold a mix of federal, provincial, and corporate bonds, further diversified by yield and duration. The best way to gain exposure in these asset classes is to invest in broadly-diversified exchange-traded funds or mutual funds.
- What are you holding? 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. Avoid adding indiscriminately to any asset class. Always consider the effect of any addition on your target asset weighting and risk profile.
- Are your investment funds doing the job? If you’ve diversified by investing in mutual funds or ETFs, 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.
Beware of tax consequences
Finally, bear in mind that rebalancing portfolios through asset sales and purchases may have unintended tax consequences or other unwanted effects. In non-registered accounts capital gains will, of course, be taxed. And in all accounts, there will be commissions or transaction fees for trading.
Remember, your objective is not to remake your portfolio in the hopes of cashing in on a stock market upswing, 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.