BackRebalance portfolio to get the best results
Make course corrections so that your portfolio reflects your goals and not market movements
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So you have gone by the book with investments—diversified into different asset classes; and allocations reflect your preference of risk, returns and holding period to get to goals. But your portfolio is not something you can set and forget. It needs regular attention to ensure that it continues to be aligned with your plans.
The performance of different investments in the portfolio may cause distortions in the allocations and require intervention to make its risk and return characteristics consistent with the investor’s preference. Manish Shah, co-founder and chief executive officer, BigDecisions.in, said, “One should ideally look at her portfolio every quarter." Some planners even recommend a review every six months.
The relative share of different assets will change over time if the returns they earn will be different. The share of the higher-return investments will become larger than the original allocation. For example, if you started with an equal share for equity and debt, over time, equity’s share in the portfolio will go up as it tends to give higher returns. Your portfolio would have drifted away from your initial preferences, and inadvertently expose you to more risk. The risk may be that the portfolio becomes more volatile if there has been a run-up in the volatile asset class, such as equity. Or, the goals may be under-funded, if the portfolio has become skewed towards investments with lower returns. Moreover, as one asset class becomes predominant, the benefits of diversification are lost to the portfolio. “While reviewing the portfolio, check if any assumption went grossly wrong," said Shah.
Rebalancing the portfolio helps to get it back on track. This is done by reducing exposure to the asset class whose allocation has increased beyond what was intended and adding to the asset class whose share has fallen. For example, if the current bull run in equity markets has taken the equity exposure to beyond the, say, 60% that was suitable for your needs, then you sell equity to bring down its share. And you invest it in debt to bring it up to the 40% exposure.
Rebalancing is also a strategy that allows you to sell high and buy low. An asset class will be overweight in a portfolio when its value is rising. When you rebalance to pare the exposure, you are selling when the price is up and booking profits. Similarly, when you invest into an asset class that is underweight in the portfolio, you are buying when the price is low.
Rebalancing brings discipline to investment activities. “You rebalance or resize your portfolio, that is aligned to internal condition (change in personal goals), irrespective of external conditions (market levels)," said Gaurav Mashruwala, a Mumbai-based financial planner.
Portfolio rebalancing involves assessing the current value of the individual asset classes in the portfolio and the total portfolio value so that the share of each in the total pie can be determined. The preferred asset allocation is compared with the current proportions of each asset class to decide whether any changes need to be made. Rebalancing is best done as a process that defines how often you will review your portfolio allocations and how the reallocation will be done. “Resizing or rebalancing a portfolio once a year is more than enough," said Suresh Sadagopan, founder of the Ladder 7 Financial Advisory.
Portfolio course corrections can be made periodically, or in response to triggers drawn from the portfolio itself, or a combination of both. You can rebalance to a defined schedule: monthly, quarterly, annually or any other preference. If the portfolio has maintained the original allocation and no rebalancing is required, then the next portfolio assessment will happen in the following month, quarter or year, as the case may be.
Rebalancing at frequent intervals needs commitment of time and effort, and may yet not provide any significant benefits. Moreover, there are execution costs and taxes associated.
Another method would be to let the portfolio’s performance provide the triggers. You could define the maximum deviation from the initial asset allocation, and then rebalance only if these limits are breached. For example, you could define the equity exposure in portfolio at 50% with a maximum deviation of +/- 5%. A rebalancing exercise would be triggered only if the equity exposure in your portfolio went above 55% or below 45%. This method requires attention to changes in the portfolio proportions than the earlier method.
Sadagopan said, “A review should not be based on performance alone. Consider factors such as whether the investments are sticking to the mandate, the risk-return parameters, style of fund management, and whether the fund manager is the same."
If you are willing to take on some additional risk for better returns, then while rebalancing the proportion of the outperforming asset class may be brought down not to the initial allocation (in this case 50%) but to the outer limit defined (in this case 55%). In this way you would still have a higher exposure to the asset class that is doing well. Shah said, “Keep fundamentals in mind while rebalancing or resizing the portfolio, as these remain the same. Don’t get carried away by high returns from an asset class in the past."
Rebalancing may also be triggered by life events such as marriage, birth of a child, higher income levels and retirement to reflect the new preference for risk and returns. For example, as retirement comes closer, the focus of the portfolio has to change from growth to income. But such interventions are linked to goal milestones, and done as and when required.
The next step of the rebalancing process is to decide how the reallocation of funds will be done. The simplest option is to sell a portion of the asset class that has run up and invest into the underweight assets. But this method involves taxes and costs. Instead, you could use the regular investible surplus available to make the adjustments. For example, if the proportion of equity has gone beyond acceptable levels, use the surplus available to buy into debt, which will bring down the proportion of equity in the total portfolio.
The income from existing investments, such as dividends and interest, as also any money received from maturing investments, can also be used to make these adjustments. Have a dedicated bank account to route inflows and outflows from investments. This will give you greater control in executing the rebalancing process.
A portfolio that is not rebalanced may generate better returns in the short run, though with higher risk, since it will be overweight on an investment that is rising. Though rebalancing reduces risk, it may still face resistance because it requires to sell an investment in a rising market and buy one that is out of favour. But over the long term, the portfolio will reap the benefits of disciplined investing.
Adopt a process-driven approach that takes emotion out of the process. Keep the focus on goals rather than on market movements. Choose the rebalancing method that suits the time and effort you are able to dedicate. Tuning up your portfolio periodically will ensure that it is primed to achieve your goals.
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