Portfolio Re-Balancing – why is it important and how you can do it
Over the course of the year, the market value of each security within your portfolio earned a different return, resulting in a change in the allocation pie. This might change the investor's risk profile. While in the short term this may not have an adverse impact, such changes in risk profiles can have a far-reaching impact in the longer run. Portfolio rebalancing is a strategy that allows individuals to keep their risk level in check and minimize risk.
What is re-balancing?
Re-balancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightages of each security or asset class in the portfolio to fulfill a newly devised asset allocation. Assume an investor's portfolio worth Rs 1,00,000 is invested in equity funds (40%), Bond Funds (40%) and liquid funds (20%). In other words, Rs 40,000 will be invested in equity funds, Rs 40,000 will be invested in bond funds and Rs 20,000 will be invested in liquid funds. Let's assume that in Year 1, equity funds deliver 50% return, bond funds loose 2% and liquid funds give a modest 4% return. Overall, the portfolio has returned 8%, but that's more due to the equities.
In year 2, assume equity markets fall. So assume, equity funds fall by 10%. Also assume that Bond funds on the other hand rebound and return 9%, while liquid funds continue with 4%.
Now assume two scenarios, viz. one where the above investor switches back to his original asset allocation, and the other where the investor doesn't reallocate his assets as per his original allocation and ignores the change.
while the rebalanced portfolio appreciates to Rs 1,20,480, the value of the ignored portfolio actually falls to Rs 1,18,360. As can be seen, the ignored portfolio got swayed by the equity return in Year 1 and therefore chose not to go back on the original asset allocation, not knowing that equities as an asset class can be quite volatile in the short run. A fall drop in the equities in Year 2 was enough to result in the ignored portfolio to under-perform the rebalanced portfolio. Re-balancing strategy is, therefore, the optimal strategy.
In year 2, assume equity markets fall. So assume, equity funds fall by 10%. Also assume that Bond funds on the other hand rebound and return 9%, while liquid funds continue with 4%.
Now assume two scenarios, viz. one where the above investor switches back to his original asset allocation, and the other where the investor doesn't reallocate his assets as per his original allocation and ignores the change.
while the rebalanced portfolio appreciates to Rs 1,20,480, the value of the ignored portfolio actually falls to Rs 1,18,360. As can be seen, the ignored portfolio got swayed by the equity return in Year 1 and therefore chose not to go back on the original asset allocation, not knowing that equities as an asset class can be quite volatile in the short run. A fall drop in the equities in Year 2 was enough to result in the ignored portfolio to under-perform the rebalanced portfolio. Re-balancing strategy is, therefore, the optimal strategy.
Benefits of portfolio rebalancing
Disciplined investingRe-balancing is a vital part of investment policy - there can be no asset allocation target without the discipline to preserve that target.
Reduces riskA plan may incur higher risk if no rebalancing policy exists. This is true particularly for equity allocations, which can rapidly rise in a bull market. For instance, portfolio rebalancing ensures that in rising equity markets, the asset allocation doesn't get skewed towards equities and the portfolio correctly reflects the investor's risk profile. It also ensures that the portfolio is adequately diversified.
Buy low, sell highRebalancing is a mechanism for sensible timing - the process naturally buys low and sells high. This strategy ensures that the portfolio returns are enhanced. A clear re-balancing policy avoids the risks of ad-hoc and costly portfolio revisions.
Balanced Funds – a better way to portfolio re-balancingOne way to rebalance the portfolio is to do it ourselves. In other words, investments can be made in equity and debt funds separately and then adequate re-balancing can be done depending on how the equity and debt markets perform.
Another simple way to ensure portfolio re-balancing is to invest in Balanced Funds. Here, the fund manager does the re-balancing and not the investor. Usually, all balanced funds invest around 65-70% in equity markets and the rest in debt and money market instruments as per their stated asset allocation mix.
So when equity markets keep rising consistently, Balanced Funds are mandated to book profits and bring their equity allocation back to their stated levels. This way, balanced funds carry a low downside risk as when equity markets fall, balanced funds take a lesser hit than diversified equity funds, as their exposure to equities is low.
Thanks to HDFC Bank
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