When you set up a portfolio, you will have an asset allocation for your portfolio. Asset allocation is an investment strategy that helps balance the risks and rewards associated with investing by apportioning the portfolio’s assets as per your goals, risk tolerance, and investment horizon. In simple terms, you will set the percentages for investments in debt and equity and the cash that you will maintain. However, these percentages don’t remain the same throughout your investing horizon. They change based on the equity and debt market movements. Let’s understand how this happens.
Let’s say given your risk tolerance, financial goals and their time horizon, you have decided that your portfolio should look like this:
| Asset | % | Rs. |
| Equity | 60 | 6,00,000 |
| Bond | 35 | 3,50,000 |
| Cash | 5 | 50,000 |
Over the years, the markets seem to be doing really well and a couple of your shares zoom ahead and before you know it, your portfolio changes to:
| Asset | % | Rs. |
| Equity | 71.0 | 11,00,000 |
| Bond | 25.8 | 4,00,000 |
| Cash | 3.2 | 50,000 |
You might want to ask, ‘What’s the problem? I gained Rs. 5,00,000 – isn’t that a good thing?’ Of course, it is. However, the problem is that, you have moved away from your original asset allocation and possibly exposed yourself to more risk than is not in line with your risk profile.
This is where you, as a sensible investor, should take some action to bring the portfolio back to the original asset allocation. This is rebalancing.
What is rebalancing?
Rebalancing is 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 proportions. In simple terms, it is returning your portfolio to the proper mix of equities, debt and cash when they no longer conform to your financial plan.
Portfolio rebalancing will help you keep your portfolio in line with your financial plan. Understand that rebalancing is not an endeavor to time the market. You need to consider it as a timely reassessment and modification of your investments that will help you reach your goals while ensuring that your risk profile isn’t ignored.
How to re-balance your portfolio
There are different methods for rebalancing your portfolio.
Calendar rebalancing
Calendar rebalancing is the most basic approach. This involves analysing your investments in the portfolio at scheduled time intervals and then adjusting them to the original allocation at a preferred frequency.
Quarterly assessments might be preferred for equity investments because monthly or weekly rebalancing could be overly expensive. A yearly approach could also be considered if you have a higher risk appetite. You should determine the ideal frequency of rebalancing based on time constraints, transaction costs and your risk profile. A major advantage of calendar rebalancing over other methods is that it is less time consuming and least expensive for you as it involves less trades and the assessments are made at pre-determined dates. The downside to calendar rebalancing is that it does not allow for rebalancing on a more dynamic basis even if the markets change significantly.
Here’s how to rebalance using calendar rebalancing.
- First you need to record your investments. If you have decided on an asset-allocation strategy and have purchased the right securities in each asset class, keep a record of the cost of each investment at that time, as well as the total cost of your portfolio along with the percentages for each of the asset classes. This historical data will help you compare them with present values in the future.
- On a chosen date, review the value of your portfolio and of each asset class. Calculate the percentages for each asset class in your portfolio by dividing the value of each asset class by the total portfolio value. Compare this to the original percentages. Note if there are any significant changes. If not, it may be better to remain passive.
Constant rebalancing
A more responsive approach to rebalancing is constant rebalancing. Every asset class is given a target percentage and a corresponding tolerance range. For instance, an allocation strategy might say that the requirement is to have 30% in mid-cap equities, 30% in blue chips and 20% in bonds with a range of +/- 5% for each of these asset classes. Note that mid-cap equities and blue chips can fluctuate between 5% and 35%. When the percentage of any one asset class moves outside the allowable band, the entire portfolio needs to be rebalanced to reflect the initial asset allocation.
You can use any one of these portfolio rebalancing techniques.
- When you find that changes in your asset class percentages have distorted the portfolio, take the present value of your portfolio and multiply it by each of the percentages originally assigned to each asset class. The figures you get will be the amounts that should be invested in each asset class to maintain your original asset allocation.
- To achieve the original asset allocation, you could sell off some of the shares where profits have exceeded your expectations and invest those profits in debt. Another alternative will be to look at your other equity holdings and sell the underperformers. You could even introduce new shares or bonds in your portfolio to bring those percentages back to where they were.
It might seem okay to leave the portfolio alone, especially if you have made profits. However, the purpose of having an asset allocation is to achieve the best return for your risk appetite. Doing nothing will violate this. As a rule of thumb, when your allocations drift by 10% or more from your original allocation, you should re-balance. This could happen over time or following an abrupt rise or decline in one or more asset classes.
Portfolio rebalancing helps you stick to your financial plan. You should check your portfolio once a quarter and more frequently if there is significant gain/loss in an asset class.
