When to rebalance a Couch Potato investment portfolio

When to rebalance a Couch Potato portfolio

How and when to add more U.S. stock exposure


Couch PotatoQ: I  use a couch potato portfolio strategy with holdings that include 1/3 Canadian equity, 1/3 global equity and 1/3 Canadian bonds. I think that my ideal portfolio would actually include U.S. equity as well and be a 1/4 split amongst the four categories. I’m wary about switching 1/4 of my portfolio into an asset class that has just had a big surge, however, as I don’t want to chase returns. Would this be a good time to use dollar cost averaging and invest over a longer time period, or should I just dive in with two feet? —Mike

A: There are several things to consider here, Mike. First, should you add U.S. exposure to your portfolio? And second, what’s the right way to add it given that U.S. markets have performed well recently?

To start, depending on the type of global investments you’re in, you may have quite a bit of U.S. exposure already or you might have none. I’ll assume that you have none, but you should always look at your underlying holdings and allocation. Don’t simply assume that your global exposure is non-North American.

There are also tax considerations that may factor into which investments you should own, in which proportions and in which accounts, but let’s ignore taxes for now.

I think U.S. equities should make up a sizable percentage of an investor’s foreign exposure. That’s because U.S. markets include sectors that Canadian markets do not. And compared to other foreign markets, the U.S. is much more politically stable.

Market timing is probably the most difficult decision for a portfolio manager to make. That’s no different when you’re managing your own portfolio, Mike, so when and how to add U.S. equities is more of an art than a science.

Some market strategists consider the market to be perfectly in balance based on all available data at any given time. This is known as the efficient-market hypothesis. Proponents of this investment philosophy would tell you that you should not worry about when and how to shift your current portfolio to add a ¼ allocation to U.S. stocks.

But another group of strategists believe that inefficiencies exist, with certain stocks or sectors being overpriced or the market as a whole rising too much.  Or, they believe inefficiencies exist when investors sell the good with the bad and markets move artificially low, creating a buying opportunity for investors, as was the case in early 2009.

I personally believe that markets are mostly efficient, especially in today’s day and age when information travels so quickly. But as index funds and ETFs have become more prevalent, I think this has created some inefficiencies as all stocks in an index may rise or fall as investors buy or sell the index, even if some individual components should be rising more or less than the overall markets.

There have been independent research studies published that purport that market timing is largely an unsuccessful practice, with professionals being close to 50/50 on when to buy and sell. There are exceptions over long periods of time, but no consistent indications of what the secrets are for guaranteed investing success.

One of the reasons that it’s hard to beat markets is because market returns are simply the amalgamation of all investors in those markets. In other words, investors, on average, earn market returns, because the market is the mid-point. In much the same way you can’t have more than half of the gamblers at a casino walk out as winners, stock investors can’t all outperform.

Studies have also shown that retail investors, as measured by mutual fund inflows and outflows, tend to invest the most at the market peaks and sell the most at the market lows. In other words, retail mutual fund investors follow a buy high, sell low approach, exactly the opposite of what a successful investor would like to do.

The lesson here is to be careful about trying to time the markets, Mike, in this case and in general.

So when and how should you make a significant shift in your portfolio? I think that whenever you’re making a significant shift in your portfolio, you should consider doing it on a slow and steady basis. Maybe you do it in three pre-determined, equal tranches over a period of months. Dollar-cost-averaging helps reduce the likelihood of picking the wrong day to buy or sell an investment and instead, spreads the process over time. Furthermore, it reduces the temptation to try to time the top or the bottom—a practice that is difficult enough for a professional to get right, let alone a DIY investor.

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Leave your question for Jason Heath in the comment section or email [email protected] and he may answer it in an upcoming column.

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products.