The definition of rebalancing your portfolio goes like this – The process of buying and selling parts of your portfolio in a bid to rearrange the weight of each asset class back to its initial state. Eh, what?
More simply stated, it is returning your portfolio to the proper proportion of equities, bonds and cash when they no longer match up to your financial plan. Let’s look at an example.
Say you have decided that given your risk tolerance, financial goals and their time horizon, your portfolio should look like this:
- Equity Funds 60% – Rs.6,00,000
- Bond Funds 35% – Rs.3,50,000
- Cash 5% – Rs.50,000
- Total – Rs.10,00,000
When The Scenario Changes – A couple of your funds zoom ahead and before you know it, your portfolio looks like this:
- Equity Funds 66% – Rs.8,00,000
- Bond Funds 29% – Rs.3,50,000
- Cash 4% – Rs.50,000
- Total 100% – Rs.12,00,000
Now, your question will be “What’s the problem with that? I gained Rs.2,00,000 – isn’t that a great thing?” Of course, it is. However, the issue is you have moved away from the ideal asset allocation. This will expose you to more risk than is acceptable.
This is where you, as a sensible investor, should rein in your portfolio and bring the asset allocation back to the original state.
Portfolio rebalancing will help you keep your investments in line with your financial plan. Understand that rebalancing is not an endeavor to time the market, but a timely reassessment and modification of your target goals.
How to re-balance
You can do this in several ways.
#1 You could sell off some of the equity funds where profits have exceeded your expectations and invest those profits in debt funds so that the original percentages are achieved.
#2 Another alternative would be to look at your other equity fund holdings and sell the underperformers, if any, to generate funds to invest in debt and other liquid assets.
# 3 Introduce new funds into your portfolio and put them in debt funds and savings (cash) to bring those percentages back to where they were.
It would seem okay to leave the portfolio alone, but the whole point of having an asset allocation in place is to achieve the best return for your risk appetite. Doing nothing will increase your risks and you may not get the returns you expect.
Re-balancing is not just a macro exercise. Within the equities portion of your portfolio, you may need to rebalance those allocations also.
For example, you might determine the equity funds portion of your portfolio should look like this:
- Large-cap growth funds – 50%
- Mid-cap funds – 30%
- Sector funds – 20%
If several sector funds take off in a big way, you will be confused whether to sell or put in more money. You can do either. You just need to ensure that your asset allocation is in place.
The Price Of Doing Nothing
If you are risk adverse, having a portfolio that is more tiltled towards volatile sector funds will keep you up at night.
Let’s assume that you expected the banking sector to keep doing well and invested about 20% in banking sector funds in 2013. By the end of 2014, they would have easily become 50% of your portfolio as banking stocks gave stellar returns in 2014. If you had not rebalanced, you would have lost a lot of money in the recent bear market where banking stocks fell by almost 50%! Banking stocks have been in a bear’s grip for the last two years. Investors who had let banking stocks form a hugely disproportionate percentage of their portfolio have nothing to fall back on.
As a rule of thumb, when your assets drift 10% or more away from your allocation, you should re-balance. This could happen on its own over time or after a sudden rise or fall in the prices of one or more asset classes.
Portfolio rebalancing is an important part of sticking to your financial plan. You should check your portfolio at least once a quarter in terms of rebalancing and more frequently if you have had a significant gain or loss in any asset class.