Here’s a smooth RRSP strategy for bumpy times

This RRSP season may be particularly important for Canadians.

With the stock market moving like a wild roller coaster ride, and an uncertain economic outlook for 2019, many investors are wondering what to do with their RRSP investments this year.

When creating an investment plan for your portfolio, diversification is the most important rule. Diversification essentially means spreading your assets among a variety of investments. It can help mitigate risk and provide the potential to improve returns.

Let’s consider a real-life example to illustrate diversification:

Ever notice that some street vendors sell seemingly unrelated products - such as sunglasses and umbrellas? That may seem odd at first. When would someone buy both items at the same time? Probably never - and that's the point. Street vendors know that when it's raining, it's easier to sell umbrellas but harder to sell sunglasses. And when it's sunny, the reverse is true. By selling both items - in other words, by diversifying the product line - the vendor can reduce the risk of losing money on any given day.

If that makes sense, you've got the basics on understanding asset allocation and diversification.

Why is asset allocation so important?

By including asset classes with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories equities, bonds and alternative investments don’t always move up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset class, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset classes' investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

Why should you diversify your portfolio?

By diversifying your portfolio, you minimize the risk in your investments, as compared to putting all of your money into one asset. To build a diversified portfolio, you look for assets that haven’t historically moved in the same direction at the same time. That way, if one portion of your portfolio declines, the other portions are ideally growing or maintaining wealth.

Diversifying your portfolio with private income producing real estate investments

Canadian income-producing real estate (office, industrial, retail, multi-residential, etc.) has historically displayed low correlations to many of the traditional major asset classes, thereby providing investors with potentially valuable diversification benefits, such as improving both the efficiency of their investment portfolio and their risk-adjusted returns.  In other words, when portfolio investments are efficient, investors may achieve higher levels of return for the same level of risk.

As well, using commercial real estate to diversify a portfolio may potentially generate more consistent returns.  Commercial real estate has historically generated favourable absolute and relative total returns. Over the past 30 years, multi-residential properties, the best performing of the primary real estate classes, outperformed Canadian Bonds by over 49% and Canadian Equities by 5%. The lowest annual return for multi-residential properties was a positive 1.7% return versus -0.17% for Canadian Bonds, -31.4% for Canadian Equities, and -41.4% for Emerging Market Equities.[1]

Markets are fickle and relatively unpredictable. Since it is impossible to routinely predict future market performances, diversification is essential in reducing overall portfolio risk, offsetting volatility, and potentially achieving higher portfolio growth.

[1] Source: Investment Property Databank Ltd.  Bloomberg Inc, Morningstar Canada

 

 

KEY TERMS

DIVERSIFICATION

is the use of different assets in the construction of a portfolio. It is a fancy word for the old adage: “Don’t put all your eggs in one basket.”

ASSET ALLOCATION

involves the intentional diversification of assets in a portfolio so as to adjust the risk and expected return characteristics of the portfolio to suit the needs and tolerance of the particular investor.

CORRELATION

is an important concept to diversification and asset allocation. It is a measure of the tendency of two investments to move (or not move) in tandem with each other. Diversification works in large part by pairing low correlation or even negatively correlated assets together to reduce the volatility of a portfolio.