Rebalancing & Measuring Investment Performance

Once the individual investments have been identified and purchased, your investment portfolio will need to be managed on an ongoing basis. Typically, this will involve three basic activities:

• Monitoring the individual investments (their market prices, maturity dates, financial health and industry events)
• Re-balancing the amount of savings invested in each asset category at set time intervals or as a result of current market values
• Adjusting the individual investments and/or asset categories as circumstances change or opportunities arise

Monitoring the individual investments

There are numerous approaches to monitoring an investment portfolio and the approach that you choose should fit with your portfolio’s structure, its complexity, and the amount of time and effort you can devote to the process.

As with the design of your investment portfolio you should establish guidelines or a routine to assist with the monitoring of your investments. This routine will help to ensure consistency in the management of your investments. Your guidelines should stipulate

• the frequency of your monitoring activities
• the type of activities involved in monitoring the investments
• the criteria that must be met to trigger the sale of an investment, and
• how the proceeds from the sale are to be reinvested

Just as with your research efforts, monitoring your investments can be approached from a top-down or bottom-up process:

• A “top-down” approach means that you are going to first try to monitor the economy, each sector your portfolio is invested in and then your individual investments.
• A “bottom-up” approach means simply watching and following your individual investments first. The overall economic and industry developments are secondary activities.
• Or you can use a combination of both.

When monitoring your individual portfolio investments, your main purpose should be to monitor the investment’s financial health and then their performance within their industry. Financial performance can mean different things to different investors, but it should include the investment’s contribution to your portfolio and the issuer or company’s financial performance.

When monitoring the investment’s contribution to your portfolio, the assessment is very basic. Did the investment help you toward your financial goal? Did it pay you any dividends? Did the dividends increase or decrease during the period? Did the investment’s market value increase or decrease? Has the investment done its job within the portfolio? Are you satisfied with your selection?

When monitoring the investment issuer’s performance, you want to ask a few simple questions such as the following:

• Did the issuer’s financial health improve, deteriorate, or stay the same during the observation period?
• Did their credit rating improve, deteriorate, or stay the same?
• Did the issuer make a profit? Did the profit increase, decrease, or stay the same? Was the profit due to increasing revenue, decreasing costs, or accounting entries?
• Are the issuer’s revenues increasing, decreasing, or staying the same? Are their revenues increasing because they have increased their sales by growing their core businesses, by acquisition or by innovation into new areas?
• Are their gross and net profit margins increasing, decreasing, or staying the same?
• Is the issuer’s share of their industry’s sales increasing, decreasing or staying the same?
• If applicable, are their dividend payments increasing, decreasing or remaining the same?

Note: The majority of these questions can be answered by reading the issuer’s press releases. Each quarter, issuers are required to announce their financial results and the details must be presented consistently according to regulatory guidelines. In most cases, this makes monitoring and analyzing an investment’s financial health fairly simple.

Members’ Note: Use Generally Accepted Accounting Principles (GAAP)

When researching and monitoring an investment it is strongly suggested that you examine data that adheres to Generally Accepted Accounting Principles (GAAP).  GAAP is a set of accounting rules, procedures and guidelines developed over time that establishes a high standard for the calculation, presentation, and reporting of financial information. Financial information derived and reported according to GAAP rules is much more reliable that non-GAAP data.

In the past few years, many companies and the investment industry have begun to report non-GAAP information that is created with inconsistent and non-standardized methods. The non-GAAP information is not comparable to previously reported non-GAAP information nor is it comparable to the non-GAAP information of other issuers.

Example: Adjusted or Cash Earnings are not calculated according to GAAP. These are calculations created by the company’s management that cannot be compared to company’s prior period’s calculation of the same data and they cannot be compared with the Adjusted or Cash Earnings calculations published by a company’s competitors. Each company creates its own method for calculating non-GAAP data and the calculation can and often does change from period to period.

So if you calculate the Price to Earnings (P/E) ratio for a specific company’s stock using their Adjusted Earnings, keep in mind this ratio cannot be compared with prior period’s P/E ratio as the calculation of Adjusted Earnings may not be the same for each period. In addition, if you are comparing today’s P/E Ratio with historic P/E/ Ratios, keep in mind the historic numbers may have been calculated under GAAP and thereby give an inaccurate comparison and conclusion.

Remember: When monitoring an individual investment’s financial health, there are a number of items to look out for:

• Begin with the issuer’s press releases. By visiting the issuer’s website, you can subscribe to automatically receive their press releases by email. This will make monitoring their financial health and performance much easier and it helps to simplify the energy required.
• In addition, you should also read the regular updates provided by credit rating agencies, such as the Dominion Bond Rating Service(DBRS). DBRS regularly reviews and reports on the financial health of publicly traded companies and they provide tremendous insight into not just the company’s current financial strength, but also current trends and influences on that company’s financial health.
• Both the DBRS and the issuer’s press releases are fairly easy to read and monitor. These sources should be sufficient for the monitoring of your individual investments.
• To monitor the stock market’s view of your individual investments, you can obtain market research from many Canadian brokerage firms, independent investment newsletters and Canadian news websites. By reading these sources, you can monitor the popularity of your investments and judge whether or not money is flowing into or out of each investment. The money flows can very often help to explain why an investment’s market price is rising or falling.
• The monitoring each individual investment will be subject to the amount of time and energy that you wish to devote.

Re-balancing the amount of savings invested in each asset category at set time intervals or as a result of current market values

When rebalancing a portfolio, we are making a decision to sell all or a portion of a successful investment and to use the proceeds to buy another investment.  Typically, we are selling an investment that is in one specific asset category and buying an investment in another asset category.

Example:  We may be selling all or a portion of a Growth investment and using the proceeds to buy a Fixed Income investment, or vice versa. Typically, re-balancing does not involve selling and buying investments within the same asset category. Selling and buying investments within the same asset category would be considered an Adjusting transaction and is discussed below.

As mentioned when re-balancing your investment portfolio, you are typically selling a successful investment and buying a less successful investment. The investment has either been successful by

• appreciating in market price or
• maintaining its value

Most often when we think about re-balancing a portfolio, we envision investment success. One of our investment categories has achieved or exceeded our goals and as a result our portfolio’s actual asset allocation is out of line with our Targeted Asset Allocation. As a result, we must sell a portion of the successful asset category and buy additional investments in the less successful asset category. This type of re-balancing is done to preserve the profit made from the successful investments by selling Growth investments and buying Fixed Income investments.

Note: Target Asset Allocation refers to your investment portfolio’s optimal asset allocation as defined in your written Investment Policy Statement (IPS). For example, if your IPS states that your asset allocation should be 65% invested in Fixed Income investments and 35% invested in Growth investments, then your Target Asset Allocation would be the 65%/35% allocation. Your Tactical Asset Allocation is used as a reference guide when reviewing and re-balancing your investment portfolio.

This can be a difficult decision – difficult because you will more often than not be selling an investment that everyone says you should be buying, and you will be buying an investment that most say you should not. This feeds your innate fear of making a dumb decision. But you are not making the decision to win friends or bragging rights. You are making the re-balancing decision because it fits within the guidelines set out in your IPS, which has been designed to help your savings achieve your financial goals.

The opposite side of the re-balancing coin dictates that you should also be re-balancing by selling a successful investments and buying weak or unsuccessful investments. This type of re-balancing involves selling investments in an asset category that has maintained their value and buying investments that have declined in value. This type of re-balancing is done to maintain your portfolio’s Target Asset Allocation and to maintain the guidelines set out in your IPS.

This type of re-balancing often involves selling Fixed Income investments and buying Growth investments at a time when Growth investments are out of favour and declining in value. Re-balancing in this investment environment is extremely difficult. You are selling a safe, steady Fixed Income investment and buying a losing Growth investment at a time when everyone is telling you to do the opposite.

Note: Establishing the guidelines and criteria for re-balancing an investment portfolio is easy. Finding the discipline to consistently adhere to those guidelines is where most investors fail. Having the courage and confidence to follow your IPS and make the sell and buy decisions, as required, is extremely difficult. If you do not have the discipline and conviction to adhere to the 12-step process that proper portfolio design entails, then you best not waste your time and energy.

Remember:  Investing involves designing and managing a portfolio during both the good and the bad investment cycles.

Adjusting the individual investments and/or asset categories as circumstances change and opportunities arise

As we have discussed, no one can foretell the future of investments. As investors, all we can do is

• do our research
• establish an investment approach
• create a written investment portfolio design
• determine guidelines to assist in the management of our investments, and
• have the confidence and discipline to adhere to our investment approach and guidelines

But in addition to all of the above, we must also remain open to changes and events that are beyond our control. We must remain flexible enough to

• recognize change when it occurs
• be diligent in our research of the potential impact the changes may have upon our investment approach and guidelines
• distinguish between temporary changes and more permanent changes, and
• have the courage to adapt our investment approach and guidelines to suit the new investing environment

Change within the investment world is inevitable and constant. Investment options change, investment services evolve, technology changes, economies move quickly and slowly through the different cycles and our own personal circumstances often change.

Investing for your family ten years down the road will be different from today. Your family’s financial and personal circumstances may be different. Your investment knowledge and experience will be different. You must always remain open to change and be prepared to adapt accordingly. With this in mind, your investment approach must remain open to changing circumstances.

Change in financial circumstances

Maybe at some future date, your financial circumstances change. Maybe they improve or maybe your fiancé’s deteriorate. You must be prepared to adapt your investment approach and guidelines accordingly. Your change in circumstances may be temporary or they may be more permanent and you need to first determine which, and then act accordingly:

• For temporary changes, you may need to make small temporary changes to your investment approach and guidelines.
• For more permanent changes, you may need to revisit the portfolio design process and make more lasting revisions to your approach and guidelines.

Change in investments circumstances

In addition to changes in your family’s circumstances, changes to individual investments may also result from changing investments circumstances. Adjusting the portfolio’s individual investments may be driven by negative or positive events. For example, in October 2006 the Canadian federal government announced a change to the income tax treatment for the Income Trust units. Such a change as this may alter your decision to continue buying and holding this type of investment, and so you would need to revise your IPS and investment guidelines to properly reflect such a change.

Changes due to technological discoveries

Changes due to technological discoveries, inventions, or improvements might also create investment opportunities that did not previously exist. A new business or an old business may evolve into a great new investment opportunity, or maybe simply the investment cycle may change and prompt you to position your investment portfolio for that change.

An individual investment may also not be performing as you had expected. Maybe the company is losing sales to a competitor, a new technology, or consumer trends. Maybe the investment’s income payments have declined or maybe there is simply a better investment within that particular industry or sector. As a result, again you may need to adjust your portfolio’s individual investments.

Tactical changes

Changes in a portfolio’s individual investments to take advantage of new opportunities are often referred to as tactical changes. Tactical changes are made to try and take advantage of opportunities when they arise.

Many investors refer to specific guidelines for tactical investments within their IPS. By doing so, the portfolio can establish dollar amounts and specific investment criteria to guide the tactical investment decisions.

Example:  An IPS might state that a certain dollar amount of the portfolio be

• used to move into and out of Growth investments as the stock market moves through the different up and down cycles.
• invested in individual investments in the hope of benefiting from the investment’s rising popularity, or
• invested in inverse Exchange Traded Funds (ETFs) or as short positions in an attempt to safeguard the portfolio’s capital in a declining stock market without disrupting the portfolio’s interest and dividend income stream.

Each of these allocations would be classified as tactical allocations. These types of adjustments to individual investments are made to take advantage of opportunities should they arise. The allocated funds can be invested or held as a cash balance until they are needed.

Remember:  Monitoring, re-balancing, and adjusting your portfolio’s investments is an ongoing activity. Because the future is unknowable, the best investors can do is

• establish an investment approach
• create a written investment portfolio design
• determine guidelines to assist in the management of our investments
• invest time and effort in researching and learning about our investment options and the investing environment
• have the confidence and discipline to adhere to our investment approach and guidelines
• remain open to changes in our family’s circumstances and the investing environment, and
• accept when our investment guidelines and our individual investments need to be adjusted.

Remember: To be successful, you need to invest time and effort. Investing success does not happen all by itself.

Now you are ready to move on to Step 12: Measure and Monitor the portfolio’s actual annual rate of return.