Asset Allocation Helps Manage Risk

Why it's a good idea to spread your investments among different asset classes

According to indexes, stocks outperformed bonds in the late 1990s. Bonds outperformed stocks in the early 2000s. Then stocks outperformed bonds again in 2003. At the end of the decade, bonds were back on top. So how do you invest your RRSP contributions to keep up with markets that change direction so often?

Doing it right
No one can predict with certainty which investments will perform best next year and which ones will perform worst, so don't try to outguess the financial markets. Instead, manage your investment risk by determining - and sticking with - an appropriate asset allocation. That's the mix of stock, bond and cash investments best suited to your time horizon (the length of time before you'll need the money), your financial goals and your tolerance for risk. Ideally, you should consider some investment outside of Canada.

You probably do most, if not all, your investing through mutual funds. Since funds spread their assets among a large number of stocks or bonds, you gain instant diversification in your portfolio. What's more, your money is actively managed by professional portfolio managers, which takes the investment selection decisions off your shoulders.

Adjusting the mix
Once you've decided on an appropriate allocation, modify it only as you get older (and the time until you need the money gets shorter) or when your financial situation changes. That way, you won't be tempted to respond to every twist and turn the investment markets take. You want to find the ideal combination of assets that strikes a balance among your performance expectations, risk tolerance and investment time horizon.

You should rebalance your portfolio once a year - restoring your allocation to what you originally intended. Usually, you will want to sell off some investments that have posted big gains and use that money to buy more of the investments that haven't done so well. Major changes in your asset allocation should be rare, and generally in response to changes in your personal situation, not to a rally in stocks or a slump in bonds.

Measuring the results
Not all of your investments will deliver gains every year. Stocks and bonds, domestic and global investments respond differently to changes in the investment climate, so it is unlikely that your holdings would perform identically year after year. But with your money spread across many asset classes, you probably would have some winning investments every year.

While asset allocation won't eliminate investment risk, dividing your assets among several investment types may help cushion your nest egg from temporary setbacks in any one market. And, over time, allocating your retirement funds among different asset classes should produce higher returns than if you concentrated all your money in just one class.