Investing in financial markets comes with risks and rewards. And, investing your hard-earned money in a single asset class is an approach. It can increase the risk of loss due to market fluctuations or offer negligible returns if invested in safe fixed-return instruments alone.
Every investor wants to know, ‘How can I reduce the risk in my portfolio?’
One of the fundamentals of investing is Diversification. Diversification is better defined as a method of asset allocation where your corpus is invested in varied financial instruments. A well-diversified portfolio reduces the risk of loss by spreading your investments across multiple asset classes at a proportion that suits your risk tolerance and matches your ear-marked financial goals.
Diversification leads to balancing your portfolio to withstand any sudden shift in market cycles or downturns. Take, for instance, a balanced mutual fund; it is the simplest form of diversification that ensures your investment is spread across a basket of equity and debt securities such as stocks, bonds, or money market instruments. The fund managers here ensure a balanced ratio is maintained within the mutual fund portfolio to avoid over-exposure to any single security. Similarly, investors need to ensure their individual portfolio of investments too maintain a suitable risk-reward ratio and balance.
But can balancing be a one-time activity undertaken when you add an asset to your portfolio?
Well, maintaining a balance in your portfolio periodically is called Rebalancing. Rebalancing is better defined as changing the weightage of assets in your investment portfolio. This activity would entail buying or selling assets to reach your desired level of portfolio composition.
For example, as an investor, you have derived a 60:30:10 proportion of debt, equity, and fixed return assets since it suits your risk profile, goals, and time horizon. Consider a Bull Run market where equities are rallying. It causes a shift in your portfolio to a 45:50:5 ratio, over-exposing your portfolio to equities. This change could involve higher risks in case of volatility. To reduce the risks, you need to realign your portfolio to its original ratio by booking profits in equity investments. This is precisely what rebalancing entails.
Rebalancing is not necessarily reviewed across asset classes alone. Investors deep dive into their portfolios and specific funds to manage and maintain their desire ratio. Some investors set a specified time during a year to carry out periodical rebalancing; this could be monthly, quarterly, or even a yearly activity for some.
But, does periodical rebalancing alone help?
To ensure you maintain your ideal asset allocation, yes, periodical rebalancing does help to a certain extent. Although, there is a thin line between prudent rebalancing and plain trading. Especially during long periods of market volatility, DIY investors often get emotional about their investments. They rigorously track their monthly portfolio statements and, in a bid to maintain an ideal asset allocation, buy and sell investments more often than needed. In the bargain, they incur unwarranted taxation, fees, and other charges that affect their gain. This constant pursuit of maintaining asset allocation and the kick from quick gains can become a habit that could lead to over-trading.
In the previous example of a bull run market, you as an investor will have some levy to let your portfolio drift during volatile markets. For instance, your risk profile could let your equity exposure ratio go from 30 to 40, but anything beyond that could mean raising a red flag for over-exposure. So, unless the weightage in your portfolio changes significantly and points towards certain risks, you may avoid rebalancing at short intervals. In short, prudent rebalancing lets you maintain your ideal asset allocation, keeps your portfolio in check for risks, and allows you to stay on track to achieve your financial goals. So, basis your investment plan and risk appetite…
Do you know what your ideal asset allocation is?