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7 suggestions for investing RRSP contributions

Need help with your RRSP contributions? Start by fine-tuning your asset allocation.

Some things are quintessentially Canadian, like beaver ponds, maple syrup and professional hockey players recuperating from concussions. Then there is RRSP season and the ubiquitous query heard throughout the land: “Where should I invest my RRSP contribution?” Here are seven suggestions.

1. Fine tune asset allocation
For many investors, especially those following a passive approach, RRSP contributions can simply be funneled into their lagging asset class in order to rebalance toward the asset allocation appropriate to their risk tolerance. This also saves on commissions that would be incurred if the rebalancing were done by selling holdings from the leading asset class and moving the proceeds into the trailing asset class.

Given stocks trailed bonds in 2011—and remain below their historical average annual return over the past few years—rebalancing can be accomplished by directing contributions into index funds or exchange-traded funds (ETFs) tracking stocks. The rebalancing can be carried down into the sub-categories of the major asset classes (for example, foreign versus domestic equities).

2. Get some bargain-priced securities
For other investors, especially those following the value approach, the goal is to find securities trading at bargain prices. On this basis, stocks are again given the nod—thanks to the historic low in bond yields relative to earnings per share on S&P 500 stocks, according to The Boeckh Investment Letter. Whenever the gap gets this large, say the editors, stocks have in the past turned upward for lengthy periods (although the exact timing is unknown).

Given the sovereign debt crisis in Europe, one unpopular group is European bonds and equities—although it might be prudent to confine prospecting to the core countries (see ETFs tracking Germany) or multinational companies with significant international sales. U.S. housing and financial stocks were deeply discounted in late 2011 but have rallied in recent months; if uncertainties over the U.S. recovery resurface, they may fall back into the bargain bin.

3. Decide on a bond strategy
Tax efficiency suggests holding fixed-income securities inside an RRSP and capital gains and dividends on stocks outside an RRSP (but U.S. dividend stocks are often held inside the plans since U.S. withholding taxes won’t be applied). So, for some investors, the question of where to put RRSP contributions may simply default to which class of bonds to buy.

Government and real-return bonds are not good values these days but remain useful as hedges against deflation, inflation and financial crises. Corporate bonds have relatively good yields. High-yield (junk) bonds may be purchased with reasonable safety though ETFs, and tend to fare relatively well when stocks and economies are advancing.

4. Avoid high-flyers and don’t chase what’s hot
Investing in high-flyers on the stock market can be hazardous to your RRSP. The large capital losses that can arise from individual small-cap, technology and other volatile stocks cannot be used to offset capital-gains taxes, and valuable RRSP contribution room is lost.

Buying individual stocks on the basis that the “trend is your friend” doesn’t usually work well either. As RRSPs are about investing for the long term until retirement arrives, such investments may not be suitable for RRSPs.

5. Mutual funds to avoid
Investors with financial planners and advisors may receive recommendations to invest in more mutual funds. But buying a “closet index” fund or adding another mutual fund to a portfolio already packed with them, merely results in the earning of market returns minus annual management fees ranging from 2.2% to 2.7%. The same market returns can be obtained more cheaply through broad-based ETFs charging annual fees under 0.2%. Over time, such cost savings add up.

6. Exceptions to avoiding mutual funds
Actively managed mutual funds may be OK to own if: i) the advisor is providing complementary tax planning and related services that the client values, ii) there is a chance of actually beating the market because the fund’s portfolio is substantially different from the market index, or iii) they come from fund families that sell directly to investors (such as Steadyhand Funds) and consequently charge annual fees from 1% to 1.5%.

7. Last minute contributions
Human nature being what it is, many RRSP contributions are made just days before the deadline. Rather than dump them hastily into some scantily researched investment, leave them in cash inside the plan until you have had a chance to do some due diligence.