If you adhere to basic investment advice that every experienced or even novice investor doles out, you would know that it is prudent no to put all your eggs in one basket. Eggs here refer to your investment and the basket is the financial instrument. The diversification of assets across varied instruments is referred to as asset allocation and a combination of all the assets make up your portfolio. With portfolio management, comes the inevitable tasks of rebalancing as well.
Now consider this, you are holding a tray in one hand which has 8 glasses filled with water. If you put all of those 8 glasses on side, will you be able to balance the tray in one hand? Additionally, if some glasses are filled up to the brim you will likely spill some of the water while you try to move with the tray. Your portfolio is much like this tray. It is imperative to maintain a certain balance even while investing to ensure the purpose or goal is met, failing which you may end up with tons of spilled water or even shattered glass.
This is precisely what Rebalancing is all about.
Importance of Rebalancing:
There are a few misconceptions about rebalancing; the most common one is that it boosts your returns by selling low and buying high. While to some extent this may be true for certain cases in the long run, but not necessarily a reason for you to rebalance.
Let’s take case in point, Reena recently began investing and this is what her diversified portfolio looks like:
Fund A (Equity) – Rs.50,000
Fund B (Equity) – Rs.50,000
Fund C (Debt) – Rs.50,000
Fund D (Debt) – Rs.50,000
Her initial investment of Rs.2,00,000 has been invested equally across all asset classes to maintain an equal balance. Over the next 3 years, let’s say equity has given her an average return of 12% while debt has given her 8% returns. Post 3 years her investment portfolio would look like this:
Fund A (Equity) – Rs.50,000 + 12% returns for 3 years = Approx Rs.70,000
Fund B (Equity) – Rs.50,000 + 12% returns for 3 years = Approx Rs.70,000
Fund C (Debt) – Rs.50,000 + 8% returns for 3 years = Approx Rs.63,000
Fund D (Debt) – Rs.50,000 + 8% returns for 3 years = Approx Rs.63,000
Her portfolio of investments now has a 53% ratio invested in equity, while her debt ratio had reduced to 47%. The longer the term of investment the wider this gap will continue to grow(considering ideal scenarios of stable returns). Depending on Reena’s age, income, risks appetite she needs to decide what is the ideal ratio that suits here investing plan. If a 50:50 ratio suits her best, then she must set the maximum limit she is willing to let this ratio drift before she triggers a rebalance. She could cap the value to a 5% drift letting the allocated asset drop in value to a max of 45% or rise to a max of 55% in her portfolio.
The purpose of rebalancing here is not to boost returns, but rather to manage risks. No single asset class can continually give good returns or perform consistently. The financial market can be compared to an orchestra, it is not merely every instrument’s high and low tones, but rather their combined harmonious balance in tune that makes them sound celestial and divine. So it is with the market, the right combination of risks and returns can ensure you get the best gains.
Benefits of rebalancing?
- Rebalancing portfolios periodically safeguard your investments from being overexposed to undue risks and lets you keep a keen eye over your investments.
- Periodical rebalancing ensures you proactively take action on underperforming stocks. This ensures your portfolio is aligned with your financial goals at all times.
- Rebalancing within a financial year can give you the levy to plan ahead, redeem your investments, and spread your tax liabilities across the years.
Balancing your portfolio helps you actively manage the proportion of your investments especially during highly volatile markets. Bear markets are likely to show a drop in equity ratio which may indicate a good time to further invest in equities for long term gains. Similarly in bull markets your equity ratio is likely to rise which translates into booking your profits from equities and investing them in debt instruments to maintain balance.
Long-term investments should not be made with a ‘one-time invest and watch attitude’. Based on proper financial planning and risk profiling investors must have a set ratio in mind that is periodically assessed to ensure stable portfolio performance. A drift in asset allocation must be corrected by rebalancing one’s portfolio.