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I think it’s safe to say that if we’d all been 100% invested in bonds over the past three years, our retirement pie’s would be much larger than they probably are. The problem with that kind of thinking is who could have known three years ago what was coming, and thus when to pull OUT of stocks and INTO bonds? In the investment industry we call this type of switching "market timing", and it’s extremely difficult to do correctly even 50% of the time. Usually you’re out of the market on days when you should be in, so you miss out on a big return day. For example, in the decade of the 1990’s the S&P 500 went up a total of 417%, in Canadian dollar terms. So if an investor bought the S&P500 index on Jan.1, 1990 and held it until Dec.31, 1999, they made a compounded average annual return of 24.8% per year. In each one of those years there were 250 trading days when the NYSE was open. So during the 10 years there were 2500 trading days. So let’s assume that due to market timing that same S&P investor was OUT of the stock market for the 10 best days of those 2500 days. They’re return would have fallen to 14.9% average annual return. If that same investor had missed the 40 best days over the same period, their average annual return would have fallen to 6.9% average annual return. The moral is the potential penalty of being out of the market on any given day is high, so don’t try and market time. So what’s the solution? Asset Allocation! Here’s a strategy that I’ve followed for many years, and believe that it’s an excellent trade off between market timing and prudent profit taking. I look at all of my families investments as our pie, and these include stocks, bonds, GICs, RRSP and non-RRSP investments, real estate, etc.. I then take that whole pie and divide it up on a 60%, 30%, 10% split. Meaning, I ensure at the beginning of every calendar year, our household assets are divided 60% in stocks (either individual stocks or stock mutual funds), 30% in bonds or fixed income, and 10% in cash (money markets, GICs, Canada Savings bonds). Then at the end of every calendar year I REBALANCE that pie back to the 60, 30, 10 split I had at the beginning of the year. For instance, in 1999 my stocks had a great year, my bonds lost a little, and the cash did nothing. So at the end of the year the stocks made up 86%, the bonds made up only 11% and the cash 3%. By rebalancing the pie at the end of 99, it "forced" me to take some profits from the stocks and buy Bonds when they were cheap. You can substitute your real estate for your bonds in your portfolio, since there both tied to interest rates, they’ve traditionally moved up and down at similar times. However, unless you’re renting your real estate, it won’t pay you any income like bonds do. The key to this rebalancing is that it shouldn’t be done more than once a year. If it’s done more often than that, the temptation to market time becomes an issue. This simple asset allocation strategy has proven to be very effective during both bull (1990-1999) and bear (2001-2003) markets. I’d suggest using this strategy during your peak earning years, and once you start nearing retirement, increase the percentage of your portfolio invested in bonds and cash (for instance to 50%). As these asset classes are much less volatile than stocks, and will provide an income at a time when you’ll need it. Slice your pie this way through your asset gathering years, and it should be big enough to last you throughout your retirement. Cheers, Hugh |
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