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Why you must rebalance your portfolio
Rishi Nathany
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August 11, 2007

You have successfully created an asset allocation for yourself, based on your risk profile and are investing according to that asset allocation. Is that enough? No. Over a period of time your asset allocation will change due to changing values of different asset classes and their percentages will be different from what you started out with. Due to this reason, you should periodically check your asset allocation and rebalance your portfolio to keep it in line to meet your financial goals.

Let us look at a scenario, where last year you had created an asset allocation of 50 per cent in equities, 40 per cent in fixed income instruments and 10 per cent in cash and liquid funds, with a total corpus of Rs 10 lakh (Rs 1 million).

With the stock markets booming, your equity portfolio has performed impressively and the Rs 500,000 invested stocks have grown to Rs 700,000.

During the same time period, your fixed income portion has returned 7 per cent and your cash portion has returned 5 per cent. Assuming that you have not made any withdrawals from your investments and reinvested the gains, without putting in further capital, your current asset value would be Rs 12.33 lakh (Rs 1.23 million) and your asset allocation would look like this: equities 56.77 per cent, debt 34.71 per cent, cash 8.52 per cent.

This brings about certain risks. Since the changed asset allocation does not correctly match your risk profile, it exposes you to higher levels of risk than what you are comfortable with, as it increases the volatility of your portfolio.

The balancing act

As an astute investor, you should now opt for portfolio rebalancing. This would entail one of the following options:

The idea of this exercise is to get all the asset classes back to their original allocation percentages. As an investor you might want to know the benefits of this exercise, since we are advising sale of better performing equities in a booming market.

The primary advantage of this exercise is to keep your asset allocation within your desired risk profile. During booming markets, most investors do get tempted and add more to equities, rather than book gradual profits, leading to an asset allocation mismatch, which is most painful if markets correct suddenly.

Asset rebalancing helps you avoid that and ensures your longer-term growth by forcing you to book profits when markets go up and shifting them to safer debt instruments. It brings a greater sense of discipline for an investor and provides much needed guideline to resist a greed and temptation in rising markets.

This strategy also works very well in an adverse circumstance, where equities are falling and their percentage falls below the desired allocation. In such cases, due to asset rebalancing, the investor is forced to buy more equities at lower prices by liquidating debt instruments leading to rupee cost averaging.

This will help the longer-term investor make larger gains in the next market rally. Overall, it has been seen that proper systematic asset allocation with periodic asset rebalancing gives much higher long-term portfolio gains than trying to time the market.

Time and taxes

However there is cost involved in rebalancing. Though the frequency is entirely dependent on the investor, portfolio size as well as market conditions, the main idea is that the periodic interval between successive rebalancing acts should be constant.

Since investments in direct equity and equity mutual fund schemes held for over a year are treated as long term capital gains, it is advisable for investors to undertake this exercise annually as they will save a lot on taxes.

Long-term capital gains on direct equities and equity mutual funds would be tax-free and the tax on debt funds would be very low due to indexation benefits, if sold after a year. Another way to totally avoid the impact of taxes on rebalancing is to make incremental investments, whether lump sum or systematically, in assets whose allocation percentages have dipped, while leaving the outperforming asset untouched, until one gets back to the original allocation percentages.

Investors can also employ another trigger for asset rebalancing. They can decide to rebalance their portfolio, not according to time, but rather only when any asset class changes in allocation due to market movements, over a certain percentage.

For example, an investor decides to rebalance only when asset allocations change by more than 5 per cent of the portfolio. In periods of dull market movement, where asset prices and allocation percentages do not change much, the investor can choose not to rebalance for a long period of time.

Asset rebalancing is a very important exercise for any disciplined investor who wishes to approach their investing in a systematic manner, while realising their financial goals that they have set out to achieve.

The writer is a director, Touchstone Wealth and Financial Planners

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