An important part of the indexing strategy is that you occasionally rebalance your portfolio back to its target asset allocation. I get a lot of questions about rebalancing, so I felt it was time to put together a series of posts about the idea.
For those who are new to the concept, we’ll start with a primer on what rebalancing is. One of the most important decisions investors will ever make is their asset allocation—the percentage of stocks, bonds, cash and other asset classes in their portfolio. For example, a mix of 60% stocks and 40% bonds is common in a balanced portfolio.
The problem is that asset allocations don’t stay constant. As the markets move month by month, your portfolio’s stock-bond mix will change, sometimes dramatically. If you had a 60-40 portfolio in mid-2008, the stock portion fell to about 45% by March 2009. If you were at 60-40 when the market bottomed, then your mix would be close to 80% equities today.
That’s why investors should occasionally adjust their portfolio to get it back to its target. You can do this by adding new money to the underperforming asset classes, or by selling off some of the outperforming funds and using the proceeds to prop up the laggards. In either case, the idea is to “reset” your portfolio to its original asset allocation.
Why rebalance?
One of the benefits of rebalancing is that it encourages you to buy low and sell high, so many people assume that the strategy is designed to boost returns. But that’s not actually the case. Think about it like this: if stocks outperform bonds over the long term—and we wouldn’t invest in stocks if we didn’t expect this—then a portfolio that is never rebalanced will naturally become more and more heavily weighted to equities. So more often than not, rebalancing will mean trimming back stocks and moving that money to the fixed income side. Over the long term, that’s likely to lower returns, not increase them.
If we assume an annualized return of 10% for stocks and 5% for bonds, then a portfolio that starts out with 60% in equities will naturally drift to 80% stocks after 20 years. Most investors do not want their portfolios to get more risky as they age. Rebalancing, then, is primarily about managing risk by keeping your asset allocation more or less consistent. If it does boost returns, that’s simply a bonus.
Another benefit of systematic rebalancing is that it helps investors control their behaviour. Whenever you add money to your portfolio, you need to make a decision about where to allocate those new funds. If you’re like most investors who simply follow their emotions, you’ll likely add the money to whatever asset class is hot. (How many people are enthusiastically adding to the bond side of their portfolios these days?) However, this is simply performance chasing, and over the long term, it’s disastrous. A disciplined rebalancing schedule—preferably written down in an investment policy statement—helps you avoid this trap and stay on course.
So how frequently should you rebalance your portfolio? There is no simple answer, but in my next post, I’ll look at some of the options.
Hi when I’m interesting in following Option 2 – When I make monthly contributions to my account, does that mean each time, I buy more of each fund? Ex. TD E-Series Fund 1,2,3,4?
So if I have 25$ to put in monthly, do I divide it up to ensure that afterwards, each fund has the same balance as well?
@Sherman: If you want to keep the portfolio in balance, you would add more money to asset classes that are below their target. But if the portfolio is relatively small you don’t have to worry about veering off target too much.
Hi!
Thanks for your reply. I’m not sure if I really understand what you mean. So every month, if I make a contribution of 1000$. I would add money to each fund in a way that keeps it in balance right?
Or would I just equally divide that 1000$ into each asset class?
@Sherman: It makes much more sense to add enough to each asset class to keep the portfolio in balance.
I’m torn between buying VUN or VFN stocks via TD DI or Tangerine Index funds. You seem to favour Tangerine. I have 10k and want to invest it and am about to pull the trigger. Advice?
@Matty: It’s very difficult to cost-efficiently build an ETF portfolio with $10K. This article should help:
http://www.moneysense.ca/save/investing/index-funds/ultimate-guide-couch-potato-portfolio/
Hi Dan ! In The MoneySense Guide, you say at page 288 that rebalancing with cashflow is “impractical to do this monthly if you use ETFs, as your transaction costs will be very high and they’ll overwhelm the benefits”. I’m wondering why because with Questrade, for example, buying ETFs is free. Is it because it wasn’t free in 2013 when you wrote the book ?
@Charles: Only a small number of investors use Questrade so I can’t assume that everyone can trade ETFs for free. But if you pay no commissions, then sure, you can add new money monthly.
Hi Dan, after using most of my savings towards downpayment for a house I am planning to start investing to build a retirement portfolio (30+ years to retirement). I have previously invested in mutual funds only and I was paying 85-120 bps in MERs and its time for me to switch to ETFs.
I am planning to invest $2000 every month but stick to ETF portfolio with one ETF trade every month that costs $10 (which I think is still better than paying an extra 50 bps in management fee to Wealthsimple every year). With a 25% VCN, 25% ZAG and 50% XAW over 4 months, I will keep contributing in the same pattern every 4 months. I am also planning to re-balance every year.
I noticed your model ETF portfolio is for investors with over $50,000 in portfolio size and for investors who invest in bulk (vs monthly).What is the reason for such minimum portfolio size? If it is driven by transaction fees, based on my planned trades, ETFs are still cheaper than other options. Can you please comment / advise? Thank you.
@Rahul: The $50K guideline is just an estimate and will vary depending on the circumstances. The main idea is that the $10 trading commissions can easily outweigh the lower MER of ETFs compared with an option like the e-Series funds. If you are starting from scratch and investing $2,000 per month for 12 months you will pay $120 to invest $24,000. It would be cheaper (and easier) to use e-Series funds and set up automatic monthly contributions to each fund ($500 to each asset class).
This blog is old but introduces the important ideas:
https://canadiancouchpotato.com/2012/07/30/comparing-the-costs-of-index-funds-and-etfs/
Hi Dan,
I had a rebalancing question. If using your current Model porfolio:
If I have a situation where I have an RSP, I have a spousal RSP and my husband has an RSP, how does this Model portfolio rebalancing work. I will not be putting in RSP contributions as I am putting my money in a CCPC on a regular basis (tax efficient, balanced approach). My husband is the one putting in RSP contributions monthly. I started the spousal years ago because of the imbalance with where his RSP was at and where my was at.
I don’t know how to go about keeping the rebalance in mind across these 3 accounts in the case I illustrated where one account will be having new money in it and 2 will not.
Does one look to sell something in the 2 accounts if necessary to arrive at that balance? I don’t think I could rely on just the idea of using new money to top up the account that is receiving the money and buy the underperforming funds?
It is hard to look at a portfolio to rebalance it across 3 accounts and am not sure if it makes sense to put the assets in each account separately i.e. Canada/Bonds in one RSP and the spousal and international/US (using XAW) in the other?
looking at a 40/60 fixed income/equity mix overall
any thoughts would be appreciated. thank you
I have seen the rebalance spread sheet and its intimidating because of the 3 accounts I have and I don’t know how to approach this
@Sue: I have found that managing multiple accounts is one of the most difficult tasks for DIY investors to manage. This is usually the point where it can make sense to get professional help, especially if some of the accounts are taxable.
While it is not ideal, you could do worse than simply holding the same target asset allocation in all of the accounts. You might give something in tax-efficiency but it’s better than analysis paralysis. (Just use something like ZDB for the bonds in the corporate or personal non-registered accounts.) You would would have to occasionally sell overweight assets if you are not adding new money to each account.
Hi, brand new to TD E-Series. Is there a step by step tutorial about setting up a tfsa to reflect ccp?
l am looking to get into the couch potato style of investing. Can you tell me which ETF’s are best suited for an RRSP, TFSA and a non registered account. From what l have been reading, US listed ETF’s are better suited in an RRSP for tax reasons because of the withholding taxes.
@Joe: My colleague, Justin Bender, has created model portfolios specific to account types:
http://www.canadianportfoliomanagerblog.com/model-etf-portfolios/
It is true that US-listed ETFs are more tax-efficient in RRSPs, but you do need to be careful to avoid excessive currency conversion costs:
http://www.moneysense.ca/save/investing/is-it-worth-it-to-buy-etfs-on-an-american-exchange/
What do you think of ETF bonds like ZFM & ZHY?
Hi there. I have about 60 000 to invest and I am 30 years old and don’t want to touch it till retirement with no plans on using the money. My risk tolerance is also high. I wanted to put it all in a TSFA and leave it for retirement while contributing lumps occasionally for rebalancing. I also wanted to make smaller monthly contributions of 300-500 a month to a RRSP. What is the best course of action for me out of the three (tangerine, TD or ETF) or a mix? I want to make the highest amount of return on my TSFA since earnings are tax free I’m able to take the risk for that.
So would high risk ETFs be better for the TSFA while once of the other two would be better for the RRSP?
Hi there! Should automatic contributions to each fund be equal? I contribute monthly and have been putting the same amount into all 4 of my funds and then rebalancing annually.
Should I be dividing my monthly contribution in the same percentages as the asset allocation? I have the Aggressive model portfolio in my TFSA.
@KW: If you are using e-Series mutual funds and can easily set up automated contributions to each fund then, sure, that’s likely to keep you closest t your targets. This usually isn’t possible with ETFs, though.
Hi Dan. New to investing. I’m inheriting money which will pay off all debts and the house, and will do a 6 month emergency fund. Leftover will be a little over 100k that i can invest, and i can put a minimum of 15k a year to investing after that. We make 80k a year annually.What would you do with that for a beginner? Thank you, any help is appreciated. (i’m in quebec, i don’t know if that changes anything)
@Camille: Your first step should be to have an overall plan, including whether you should use an RRSP or TFSA for your savings (with an income of $80K an RRSP is usually preferable for retirement savings). Then you should understand the relative risks of stocks vs. bonds and decide on an appropriate asset allocation for the portfolio. If you’re new to investing, it’s easy to overestimate your risk tolerance, so be careful here. In terms of the portfolio itself, if you’re comfortable learning to buy and sell ETFs, then one of the single-ETF portfolios would probably be ideal. Good luck!
If i begin investing in VGRO at 25, how do i rebalance the bonds allocation to this as i get older to reduce volatility. Or do i even need to do this?
@Jim: You can always just add a bond fund (or GICs) to the portfolio and put your new contributions there until you achieve your new target asset allocation. At some point you could also just sell VGRO and replace it with an asset allocation fund that is 60% stocks (such as VBAL or XBAL), as long as the fund is in an RRSP or TFSA and you don’t have to worry about taxable capital gains.
@CCP: If i decide to sell my VGRO, wouldnt that affect the compound interest that ive grown over (10/15+ years) in VGRO?
@Jim: No, you don’t forfeit the past growth in your investments just because you sell the investment and buy another one.
Hi Dan, I make 65K/year. I’m in my early 30s, and have 20K in TFSA and another 20K in RRSP. Currently both a/cs are invested in NEI mutual funds at 2.41% MER. I am finding that this is too high. I’m learning about investing, but atm I’m not ready to fly on my own. I am not interested in tickering with portfolio. The goal is to leave it alone till retirement while saving / making monthly contribution of ~$500. Given my situation, do you think I should stay where I am in MF because my amt is small or switch to ETF/Mutual Index Funds? Could you please recommend some ETFs/Mutual index funds for me to look into? Thanks so much! :)