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.
