Skip to main content

Portfolio’s risk-return balancing

Rebalance your portfolio periodically to retain its risk and returns characteristics


   Seasoned investors can vouch for the fact that the key to maintaining a good portfolio mix is periodic portfolio rebalancing. Rebalancing helps in maintaining the portfolio's original risk-return characteristics.


   Asset allocation strategy is crucial to building a strong portfolio. It determines the proportion of any given asset class represented in your portfolio. An older and risk-averse investor has a retirement asset allocation of predominantly fixed income investments. A young and aggressive investor will have the bulk of his money in the stock markets. In a nutshell, a portfolio's asset allocation strategy determines its risk and returns characteristics.


   What happens to the original asset allocation when one asset class yields phenomenal returns while others pale out? As different asset classes give different returns, a portfolio's asset allocation changes considerably with time. It is essential to retain the original risk and returns characteristics of a portfolio. Investors can rebalance by buying and selling portions of their assets in order to regain the weight of each asset class back to its original proportion.

Time to rebalance portfolio    

When should an investor balance his portfolio? The characteristics of the portfolio's assets determine the frequency of rebalancing. If there is a high correlation among the returns of a portfolio's various assets, the performance of assets under the given market conditions will be similar. This significantly reduces the likelihood of the portfolio drifting from target allocation, and hence such a portfolio has little need for rebalancing.
   

Rebalancing becomes critical under these circumstances:


• It is time to rebalance the portfolio when some of your investments become out of alignment with your goals
   
• Your portfolio loses its original asset allocation proportion when some asset classes become over-represented
   
• If your risk profile has changed
   
• When an asset class makes a significant profit or loss
   
• Another strategy is to periodically rebalance the portfolio - say once every six months

Strategies to rebalance portfolio    

How can you rebalance your portfolio? There are three strategies for rebalancing a portfolio that has strayed away from the original asset allocation mix. The most common strategy is to sell star performing stocks and reinvest the profits in debt instruments to regain the original equity-to-debt ratio.


   Most investors hesitate to rebalance at a time when the stock markets are yielding lucrative results. Rebalancing is essential to maintain the risk level of your portfolio.


   Another strategy is to weed out under-performers from your stock basket and reinvest the money in bonds or cash. This way, you can also get rid of risky stocks that are worthless.


   If you have surplus money, you can make fresh investments and raise the percentage level of asset classes that have trimmed down.


   Portfolio rebalancing helps maintain an acceptable level of risk, and in times of turbulence, will prevent gross erosion of portfolio value.

Avoid frequent churning    

When implementing a rebalancing strategy, do not forget to factor in time spent, redemption fees and trading costs. These expenses will reduce the returns from the portfolio. Hence, rebalancing too frequently is not advisable.
   

CASE STUDY

SHANKAR has invested Rs 5 lakhs in stocks and bonds. Since his risk appetite level is medium, he has invested 50 percent of his money in stocks and 50 percent in bonds. In the bull run, the representation of stocks in the portfolio went up to 70 percent. His original investment of Rs 2.5 lakhs in stocks grew to Rs. 7 lakhs. His investments in bonds moved up marginally to 30 percent at Rs 3 lakhs.


   The portfolio has churned out to be quite risky with excessive exposure to equity. Shankar can sell 20 percent of his stock portfolio that have fared well and use those proceeds to invest in bonds to reset the original equity-debt allocation ratio.


   After rebalancing this way, the equity-to-debt ratio has come back to 50:50 at Rs 5 lakhs each.


   If Shankar hesitates to sell stocks performing well, he can explore investing more money in bonds to regain the original asset proportion.

Consequences of not rebalancing this portfolio    

What happens if Shankar does not rebalance his portfolio? Assuming that during the bull run Shankar's portfolio has an equity exposure of 85 percent, only 15 percent of his portfolio is invested in more stable and less risky debt instruments. Assume after a few months, the stock market bubble bursts and a bear market ensues. The incessant selling in the markets plunges investors into gloom.


   Consider a scenario when the crumbling market pulls down Shankar's equity holdings to peanuts. With his debt exposure already at a dismal 15 percent, Shankar has no safety net to fall back on in these troubled times.

 

Popular posts from this blog

Understanding Your Cibil Credit Information Report

   WE ARE all familiar with the anxiety and uncertainty that we feel when applying for a loan. After all, it's the lender who decides whether we can own our dream home, our first car, or whether our children can pursue higher education. In a nutshell, a better life depends on the lender's decisions.    While other factors do play a part in the lender's decision, the Cibil Credit Information Report ( CIR ) plays a crucial role in a lender's decision to approve a loan application.    Previously, lenders would treat all loan seekers equally. Each applicant, if approved by the lender's internal credit policy, would be charged at the same interest rate for a particular loan size and purpose. The lenders would charge a higher interest rate to all the borrowers, in order to compensate for the possible default of a small portion of the loan disbursed. In other words, it's like a professor (the lender) punishing an entire class (borrowers) for the mischief played b...

What are the factors affect the changes in Interest Rate of Fixed Deposits?

  What are the factors affect the changes in rate of Fixed Deposits? Fixed Deposits are now considered to be a very old fashioned method of saving, but still attract many investors since they have guaranteed returns at the end of the tenure of the investment at a decent interest rate. There are various factors that affect the rates of interest for a Fixed Deposit. Policies of the Reserve Bank of India   - The several norms and restrictions posed by the Reserve Bank of India , in order to gain optimum control over credit and inflow and outflow of fund throughout the country. The repo rate changes, cash reserve ration tends to change and these changes affect the banking products like Fixed Deposits, loans etc. Recession   - When unemployment in a country crosses the benchmark set Recession hits, and slowly the country faces an economic slow movement, affecting the purchasing power of the people in the country, forcing the Reserve Bank of India to release more funds in the financial marke...

Myths about Exchange Traded Funds (ETFs)

1) ETFs Are Similar to Individual Stocks: Like MFs, ETF consist of an underlying portfolio of securities that's designed to follow a specific index or investment strategy. Hence, they are as diversified as various mutual funds. 2) ETFs Only Invest in Equity: Since they are listed on the exchange, the general belief is that ETF only consists of equity asset class. Globally, ETFs are available across asset classes – equity, debt, commodities, real estate and so on. In fact, over the past couple of years, India has also seen the emergence of Gold ETFs. 3) All ETFs Are Index Funds: ETF started as a fund which used to track indices and hence they were branded as index funds that are listed. However, ETFs have progressed rapidly and are no longer associated only with passive index funds. Globally, we have seen the launch of actively-managed ETFs. In India, also we recently saw the emer gence of fundamentally-weighted ETFs on Nifty, which busts the myth that ETFs are index funds and can...

REC Tax Free Bond Issue

Tax Saving Mutual Funds Online Current open Infra Bond Application form   Download REC Tax Free Bond Application Forms REC (Rural Electrification Corporation) is going to issue tax free bonds and the issue will open on March 6 2012 and will close on the 12th of March 2012 When you buy 80CCF infrastructure bonds, the amount you invest in those bonds get reduced from your taxable income but in these bonds that's not going to be the case. The interest on these bonds will be tax free and they are similar to the other tax free bonds like the HUDCO, NHAI and PFC issues. For the two of you interested in knowing this – these bonds are tax free under Section 10(15)(iv)(h) of the Income Tax Act. Now on to the issue itself and let's start with the high credit rating that the issue has got. The REC tax free bond issue has been given the highest rating by all issuers since the government owns the majority stake (66.8%) in REC, it has been consistently profit making,  this is a se...

Good Loan

Why Is It A Good Loan?: Loans against gold are cheaper and better than personal loans as the former are available at lower interest rates. In contrast, the interest rates on personal loans are not standardised and can vary from bank to bank. Also, a personal loan depends on a host of factors including, the borrower's salary, profession and the purpose for which the loan is being taken.      For instance, the interest rate on a personal loan of 5 lakh falls in a wide range of 15-30%. But loans against gold are available for as low as 11%. Secured borrowing such as a loan against gold, investments or property is cheaper because it is backed by some assets, which command a good value at any point of time. If the borrower defaults on the loan, the banks can liquidate the assets to settle the loan account.    Being a secured loan, the risk of default and credit losses is significantly lower in this loan compared to other forms of loan for personal use. Given the lower risk, gold loa...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now