Rebalance to reduce risk and maintain your plan

Common wisdom among financial analysts holds that investment success depends less on the individual securities you buy than on your strategic asset allocation — how you divide money among the main asset classes: stocks, bonds, and cash. Your weightings can, however, easily go awry as markets rise and fall. The stock market boom of the late 1990s, for example, gave many investors far more equity exposure than they planned. In some cases, a stock target weighting of, say, 55%, rose to 80% or more.

The danger of being overexposed

Those people were easy prey when the bear struck in 2000. If only they had moved some stock gains to bonds or cash. Bonds looked drab in 1999, but did well in 2000-2002.

That’s the point of rebalancing. Periodically bringing your weightings into line makes you less vulnerable to a downturn and boosts your chances of benefiting when an under-performing asset class takes off. Always remember that stock and bond markets tend to move in spurts.

It’s easier said than done, however. Rebalancing is psychologically challenging since you must sell your winners and move that money to an asset class that hasn’t been doing as well.

How it works

Rebalancing should be done systematically and with discipline. Here are the two most common approaches:

Use a set schedule. At predetermined intervals — for example, every three months — investments within asset classes that have experienced more growth are sold, and proceeds used to purchase investments in lower-performing asset classes. This periodically restores the asset mix to original proportions.

Use a threshold amount. A need for rebalancing can also be triggered when any one asset class goes off target by a certain percentage, or the total percentage change across asset classes exceeds a certain limit. Some mutual fund company programs will automatically adjust your holdings, using one or both of these methods.

Consider tax

Before implementing any rebalancing strategy, however, it’s important to look at the potential tax implications. You don’t want any unpleasant surprises when you fi le your tax return for the current year.

Rebalancing is easy for mutual funds in a Registered Retirement Savings Plan (RRSP) or Registered Education Savings Plan (RESP). There is no tax bite when you redeem units. Rebalancing a taxable account is a bit more difficult. Normally, investors face capital gains tax whenever they sell a fund for more than it cost to buy. But there are two ways to rebalance without triggering tax.

One solution is to hold mutual funds that are set up within corporate structures. There is no tax due when switching among funds under the same corporate umbrella. Tax hits only when you leave the structure.

The other solution is to simply channel all new investment money to the under-performing asset groups until you are back to your basic allocation. With this approach, it may take a little longer to get your portfolio back in balance, but it has no tax implications