Financial Basics 10 - Investing and Re-balancing

This post is about managing your investments and accounts, how to make investments and how to re-balance your portfolio of investments.  



We will revisit the example portfolio from post #7 and the determination of which funds we will put in particular accounts. Then I will propose an easy way to make the contributions and buy the funds each month. We will make use of a Google Sheets spreadsheet that helps us determine which funds to buy in each account. 

Investing Example

You will recall from the example in post #7 that we have a portfolio of 4 funds.  One in each of the asset classes; namely bonds, Canadian, US and International equity. I will assume that you will be investing in 3 different accounts, an RRSP, a TFSA and a Taxable savings account. All the accounts are at a single bank or broker and are self-directed. 

The table below shows the funds I am going to use in the example in this post. Your funds and percentages may be different. 

	Class	ETF	Portfolio
		Name	(%)
	Bond	XBB	25
	Canadian	XIU	30
	US	XSP	30
	International	XIN	15
	TOTAL		100

We want to place the funds in accounts to minimize our taxes paid each year. The following table from post #9 shows the distribution of funds by account and by percentage. Remember this distribution is dependent on the proportion of your assets in each account. In this example 63% is in RRSP, 24% in TFSA and the rest in the Taxable account.  If that distribution changes then the percentage of funds in each account also changes. You can use my Portfolio Live spreadsheet to do this calculation for you. 

	Class	ETF	Portfolio		Account (%)
		Name	(%)	RRSP	TFSA	Taxable
	Bond	XBB	25	25
	Canadian	XIU	30		17	13
	US	XSP	30	23	7
	International	XIN	15	15
	TOTAL		100	63.0	24.0	13.0

The table below shows the distribution by amount for the one year of savings, if the contribution to the accounts are $14.4k RRSP, $5.5k TFSA and $3k to Taxable.

	Class	ETF	Portfolio		Account ($)
		Name	($)	RRSP	TFSA	Taxable
	Bond	XBB	5700	5700
	Canadian	XIU	6900		3900	3000
	US	XSP	6900	5300	1600
	International	XIN	3400	3400
	TOTAL		22900	14400	5500	3000

Let's use this example from post #9 and see how we would buy the funds in a way to minimize purchase costs and effort. 

If you are not familiar with self-directed accounts, the contributing of cash and purchase of funds are two separate banking transactions. The contribution or transfer of cash is free, but the purchase of ETFs will require a transaction fee (typically $10). Cash is contributed to an account as one step, and once this has cleared (in a day or two) the cash shows up within the account and then a fund purchase transaction can be executed. 

The table below shows the contributions made to each account by month and then the fund purchase transactions that are made using the cash within the account. The fund purchase transactions are shown by fund and by account. (You will see later on I show the same example, but with fund purchase transactions every 2 months instead of every month to save on transaction fees.)

The total savings in this example is $22.9k for the year, or an average of $1,910 per month. I've rounded this off to $1900 a month for 11 months and then $2000 for December.  

In January, $1900 is contributed to the RRSP and then XBB is purchased with this cash. RRSP contributions continue until $1100 in August which adds up the $14,400 room in the RRSP. Cash contributions continue to the TFSA and then the Taxable account.  

Three contributions of $1900 just happen to make up the $5700 target for XBB in the RRSP. In April, XIN is bought and then $1500 in May to make up the total $3400.  Also in May, $400 is used to purchase XSP, then XSP purchases continue until the $1100 in August which uses up all the cash in the RRSP. 

Also in August, contributions to TFSA begin and purchases in the TFSA account starting with $800 of XSP (Remember from the table above XSP will be in both the RRSP and TFSA) and another $800 toward XSP in September which finishes off all XSP purchases.  In September $1100 of XIU is purchased in the TFSA and purchases continue to November to fill the $5500 of room in the TFSA. The remaining $3000 of XIU is purchased in the Taxable account in November and December. 

		Contributions ($)				Fund Purchases ($)
						XBB in	XIN in	XSP in	XSP in	XIU in	XIU in
	Month	RRSP	TFSA	Taxable		RRSP	RRSP	RRSP	TFSA	TFSA	Taxable
	January	1900				1900
	February	1900				1900
	March	1900				1900
	April	1900					1900
	May	1900					1500	400
	June	1900						1900
	July	1900						1900
	August	1100	800					1100	800
	September		1900						800	1100
	October		1900							1900
	November		900	1000						900	1000
	December			2000							2000
	Total	14400	5500	3000		5700	3400	5300	1600	3900	3000
	By Account							14400		5500	3000
	By Fund					5700	3400		6900		6900

The scenario shown above assumes that you make a fund purchase each month and it turns out there are 16 in the year. At $10 per trade, that's a total of $160 per year in transaction fees, which isn't that bad, but is it optimal? 

In January and February we contributed $1900 each month to the RRSP and then made a trade each month to buy the XBB fund. We could have contributed $1900 cash in each month and then made a single purchase of $3800 of XBB in February. This would have saved us a $10 transaction fee. If we assume we make an average of 5% growth (interest plus gains), then we would have lost $8 ($1900 x 5% x 1 / 12) in interest in 1 month, but saved $10 on transaction fees. 

The breakeven minimum amount to purchase, assuming you are only going to delay 1 month, is $2400 ($10 x 12 / 1 / 5%). For two months it would be $1200 ($10 x 12 / 2 / 5%).  Our monthly contribution is $1900, so we should delay the purchase a month until we have $3800. So let's recast the investment timing for our example year using this rule of thumb. 

You can see the contributions of cash continue monthly, but the fund purchases are every other month. You can see there is a purchase of $1600 of XSP in September, which is under my $2400 guideline, but there is only $1600 of XSP in the TFSA account so that purchase has to go ahead. 

		Contributions ($)				Fund Purchases ($)
						XBB in	XIN in	XSP in	XSP in	XIU in	XIU in
	Month	RRSP	TFSA	Taxable		RRSP	RRSP	RRSP	TFSA	TFSA	Taxable
	January	1900
	February	1900				3800
	March	1900				1900
	April	1900
	May	1900					3400
	June	1900						2300
	July	1900
	August	1100	800					3000
	September		1900						1600
	October		1900
	November		900	1000						3900
	December			2000							3000
	Total	14400	5500	3000		5700	3400	5300	1600	3900	3000
	By Account							14400		5500	3000
	By Fund					5700	3400		6900		6900

That's only 8 purchase transactions at a cost of $80.  Pretty easy to manage!

About Re-balancing

Re-balancing is about keeping the percentages of your asset classes in your total investments close to the portfolio you decided to use.  

Here's a decent article in wikipedia on the subject.

Remember the portfolio percentages in the example again. 

	Class	ETF	Portfolio
		Name	(%)
	Bond	XBB	25
	Canadian	XIU	30
	US	XSP	30
	International	XIN	15
	TOTAL		100

What can happen over time is that one of the investment funds appreciates more than the others, thus resulting in a higher percentage of the total than when originally purchased. It may mean that you will have to sell some of one fund and buy some of another. You will likely sell some of the fund that has increased (the high one) and buy more of the one that has gone down (the low one). In effect you are buying low and selling high.

If you sell a fund in the RRSP and TFSA accounts it does not incur any taxes, but if you sell a fund in the Taxable account that has realized a gain this will incur some income tax. Since this is tax payable today, and not deferred until we retire, this is something we try to avoid. So remember to:

Try at all costs to avoid selling funds in the Taxable account that have an unrealized capital gain. 

An unrealized capital gain is a stock or fund that has increased in value, but you haven't sold it yet.  If you sell it, then you will realize the gain and have to pay taxes on the gain. 

In a situation where you have stocks and mutual funds in a Taxable account that have a significant gain it is best to put off selling those until you retire or when you are at a lower marginal tax rate.

If you are actively saving, you may be able to re-balance by just changing which funds to buy each year. If you are actively selling, such as in retirement, you may be able to re-balance by just changing which funds you sell each year. 

The math to do this re-balancing while buying or selling is quite simple, but with three or four different ETFs, three (or four) accounts and a priority system where the funds are only in some accounts, it becomes an accounting problem. The best solution to this is to use a spreadsheet.

A real T-shirt I own - a present from some colleagues.

If you haven't read the post on my portfolio re-balancing spreadsheet - Portfolio Live, then you should do that now. I will show an example using that spreadsheet on how to determine which funds to buy in order to keep the portfolio in balance. 

The table below are the basic inputs to the Portfolio Live spreadsheet and is the same inputs used as the example above. The fund rank is the order to place the funds into the accounts. They are ranked in based on the amount of taxable income generated from their yield, same as presented in post #9. There are no existing fund units owned (blank values under # of units). 

The spreadsheet determines which funds to buy in each account. You will note these values are the same as the example above.  

Let's look at an example where the existing holdings are out of balance to the portfolio. We only have two existing funds and one of them is in the wrong account. We have 200 shares of XBB ($6400 worth) in the RRSP account and 200 shares of XIN ($4900 worth) in the TFSA account. We put these share units in the current holdings and then enter the amount of cash we are going to invest, which just happens to be the same annual contribution amounts in the example above. 

The spreadsheet then calculates the buy and sells you need to make in each account to balance the portfolio.

Note that the XIN in the TFSA is to be sold and then bought in the RRSP and there is just a small purchase of XBB since we already own some of that. The total amount of purchases is $22,900 which is the amount of cash we specified to be invested.  

You can use the spreadsheet with no cash specified, to do a pure re-balance. You can also use the spreadsheet with negative cash specified to determine the re-balance while you are withdrawing funds during retirement.  

Other Resources

Canadian Couch Potato has a short post on the subject of optimal asset allocation decisions.

Dave Liggat's post that inspired me to write my Portfolio Live spreadsheet.


Future Posts

• Optimal frequency of re-investment of cash dividends (or interest).
• Impact on portfolio re-balancing of increasing Bond % over time.
• Impact on portfolio re-balancing of increasing percentage of income saved over time. 

Disclaimer:  These posts are not fully comprehensive financial advice.  You should seek your own qualified investment, tax and legal advice.