Besides smelling the fresh air and raking the yard, I’m adding one more action to your fall list. This one is much less poetic, but oh so essential: I named rebalancing your portfolio, a task which should be among your essential precautions to take before winter.
Since the start of the year, investor morale has remained good with favorable stock market results. But be careful, there is a trap. It is tempting to believe that it is finally possible to breathe and stop worrying too much about the portfolio that gave you strong emotions in 2022. However, even if it is true that current returns are pleasant, some “yellow-orange” signals should prompt you to be a little cautious.
Data from recent months, both in Canada and the United States, show a tight job market. Not to mention credit card debt, which has exploded since 2021. Even if retail sales remain surprising in Canada in the last quarter, we can assume that consumption will eventually slow down. Without calling for disaster, this fragile economic context could be transferred to the stock market since the profitability of certain sectors or certain companies will suffer drastically! Finally, let us point out that certain stock market valuations, particularly those of large American capitalizations, are quite high, which implies not panicking, but managing the risk.
What does it mean to rebalance
Should we refrain from buying stocks because they are selling at a high price? Not necessarily. Depending on your objectives and your risk tolerance, it is possible to buy them all the same by focusing on diversification. But if there is one certainty here, it is that you should at least absorb the rise of certain securities or asset classes which have shown strong growth in recent years.
For example, if your allocation between stocks and bonds at the start was 60%-40%, it is possible that over the years and the date of IPO of your investments, this weighting has changed because the performance of the classes of assets and funds you use is not uniform. If the proportion of stocks is now 75%, your portfolio has become riskier, even if you like the return you are seeing since the beginning of the year… It might be wise to lock in and cash out the gains made and reallocate an amount from the portfolio to fixed income and alternative investments.
Let’s go further. If, in the equity portion of your portfolio, the returns impress you, you may not have the reflex to call your broker or your representative (these calls are often reserved for times when the markets are difficult…). But right now, strong past returns may mean overexposure to large-cap U.S. stocks, not to mention the “magnificent seven,” which alone account for nearly a third of the composition of the S&P 500, according to Ycharts , and more than two-thirds of its growth over the past five years, according to Bloomberg.
Knowing that the technology sector and artificial intelligence probably largely explain your current returns, the idea is not to deprive yourself of it, but precisely to seize this opportunity to protect yourself while everything is going well. To achieve this, you can sell part of certain securities or fund shares in order to pocket a gain and reinvest it in your portfolio in order to secure it through better diversification.
Examples of diversification
You already know that it is impossible to predict the markets. It’s a challenge to know when to sell stocks that are doing well, but it’s also a challenge to determine where to direct the cash released by portfolio rebalancing. Diversification can take many forms, including the right mix of company size, industries and geographic regions.
Currently, the context lends itself well to focusing on small and mid-caps to complement larger companies. These stocks sell for a much more reasonable price than large-cap stocks, which makes up for the fact that they are potentially riskier than larger company stocks. While it is impossible to predict the future, the current rate cuts will benefit this asset class, whose profitability is more influenced by debt service. If you buy them at a reasonable price, you will one day benefit from their growth, even if, along the way, volatility may be more marked.
The portfolio must also find a balance between cyclical, defensive and sensitive sectors, as well as Canadian, US and international assets. You don’t have to be an expert, don’t worry. You can simply ask the question to see what percentage of your portfolio is currently invested in US large-cap and technology companies. The answer might surprise you.
Another element to keep in mind to ensure good risk diversification is to take care to select securities or asset classes that do not have a high degree of positive correlation between them. For example, investing in liquid alternative investments in addition to stocks and bonds should allow you to soften downturns. On the other hand, you sometimes have to give up a little yield during periods of strong growth. As with many elements of portfolio management, you have to be patient to observe the results.
Financial planner, Sandy Lachapelle is president of the independent firm Lachapelle Intelligent Finances.
