3 min read.Updated: 06 Aug 2021, 05:27 AM ISTArun Kumar R.
Rebalancing regularly keeps your portfolio risks in control and enhances returns
In Greek mythology, master craftsman Daedalus and his son Icarus were imprisoned on an island by King Minos. To escape, Daedalus created two sets of wings made of wax and feathers. As they planned their escape, he had two warnings for his son.
Warning 1: He warned Icarus not to fly too high, close to the sun, because his wax wings would melt.
Warning 2: He also cautioned Icarus not to fly too low, since his wings would absorb moisture from the sea water and become too heavy to fly.
Icarus unfortunately ignored the first warning of his father. He was so intoxicated by the experience of flying that he went higher and higher. As he went closer to the sun, the wax in his wings melted and he fell into the sea and drowned. The saying “don’t fly too close to the sun" is a reference to Icarus’ recklessness and hubris.
But what does this have to do with investing?
At the current juncture, we have a strange situation where some investors are worried about the sharp rise in equity markets and think of this as flying close to the sun and are cutting down their equity exposure. Their argument goes along the lines of—valuations are above historical averages, lot of new investors are entering equities, initial public offerings (IPOs) are increasing and most of them are getting oversubscribed, 12-month FII flows are close to historical highs, making us more vulnerable to global events, global inflation is rising, domestic earnings growth expectation is very high and has no room for error, covid cases are rising in some parts of the country, etc.
On the other hand, we also have investors who are excited by the same market rally and are worried about flying too low (given the low fixed income returns) and are increasing their equity exposure. Their argument goes along the lines of—valuations may remain high given the context of low global interest rates and excess liquidity, vaccine drive is picking up, we are at the bottom of the earnings cycle and entering a strong earnings growth environment, robust pent-up demand led by higher savings, corporate balance sheets are in the best shape, consolidation of market share across top players, low interest rates, banking sector in a better shape and the worst of NPA cycle is behind us, early signs of revival in real estate and corporate capex, revival in manufacturing supported by PLI schemes, China+1 etc.
Both sides seem to have valid arguments. How do we decide?
All of us have a different mix of equity, debt and gold in our portfolio depending on our investment goal, time frame, ability to tolerate temporary declines and return expectation. This is referred to as the asset allocation mix. In Daedalus’ parlance, this is your recommended flying zone.
Now, whenever the equity market does exceptionally well, the allocation mix tilts towards equity and starts exceeding the original mix. This is the time to pay heed to the first warning of Daedalus, “Don’t fly too high".
While what is too high does not have a precise answer, a good starting point would be to have a 5% band. Whenever your equity allocation in the portfolio exceeds the original planned allocation by more than 5% of the entire portfolio, then reduce the equity allocation and bring it back to the original asset allocation level.
Similarly, whenever there is a large temporary market fall, the overall equity allocation comes below the original mix. This is the time to pay heed to the second warning of Daedalus—“Don’t fly too low." So, whenever your equity allocation in the portfolio becomes lower than the original planned allocation by more than 5% of the entire portfolio, then increase the equity allocation and bring it back to the original asset allocation level.
This simple activity can be done once every year. But if there are sharp deviations of more than 10% during the year, then Daedalus’ instruction can be carried out immediately within the year.
Daedalus’ simple advice is called “Rebalancing" in the investing world.
Rebalancing, when regularly done, keeps your portfolio risks in control and over the long term has been proven to enhance your portfolio returns.
Remember that there will always be uncertainty regarding the future direction of the market and along with it comes the inevitable intellectual temptation to predict the market direction and make major adjustments to your equity allocation.
The key is to resist this urge and when in doubt about what to do with your equity allocation, go back to Daedalus’ advice— “Don’t fly too high, but more important, don’t fly too low!" Happy investing.
Arun Kumar R. is head of research - mutual funds, fundsindia.com.