Are you rebalancing your investment portfolio wisely?
Mar 01, 2014

Author: PersonalFN Content & Research Team

As a prudent investor, you must be diversifying your investments across asset classes and also within asset classes. This is why you not just invest in fixed deposits and gold but also in equity and real estate. When you invest in equity; you invest in few bluechip companies at the same time you like to buy stocks of some well performing mid-sized companies. Very few of you must be relying on a single bank for keeping a Fixed Deposit (FD); be it a Public Sector bank having the backing of the government. You have FDs with multiple banks. Moreover, you might also be investing in fixed deposits offered by companies. A debt mutual fund is another investment avenue for taking exposure in debt. You buy gold Exchange Traded Funds (ETFs) and buying physical gold is almost irreplaceable in India. So, you are doing many things right but how frequently do you rebalance your portfolio?

What is portfolio rebalancing?
In simple words, portfolio rebalancing is nothing but correcting the deviations in the original allocation. For example, initially you invested 70% in equity, 20% in debt and 10% in gold. After a few years, equity became 80% of your portfolio and gold became 15% of your portfolio. As a portfolio rebalancing exercise you would cut exposure from equity and gold and put the money into debt to achieve the asset mix you had started off with.

Why is it necessary to rebalance your portfolio?
As you already know, the idea of investing in different asset classes is to diversify risk. Ideally, you should invest in asset classes having low or negative co-relation. This helps you safeguard your investments from a bad phase in a particular asset class. If you follow asset allocation, wherein you predominantly invest in asset classes whose market value is subject to change, you must track the changes in the value of assets. It is possible that an asset class drifts significantly away from the initial allocation due to appreciation / depreciation in its own value or appreciation / depreciation in the value of other assets.

What if you don't rebalance?
Result can be positive or negative depending on various factors. Suppose, you have significant investments in real estate and equity with tiny exposure to debt, you might benefit by not rebalancing during upswings in real estate and equities. However, you stand to lose when tide turns against these assets. This brings us to a crucial aspect, risk management. If your initial allocation is based on risk appetite and your financial goals and if you don't rebalance, you are exposed to higher risk. Moreover, you may also fail to optimise the returns if you don't rebalance.

Power of Rebalancing
Power of Rebalancing
For illustration purpose only
Assumptions: Asset mix remains 7:2:1 in favour of equity, debt and gold respective.
Initial Investment amount Rs 1 lakh
Every year, Rs 1 lakh are invested in the proportion of 7:2:1 in equity, debt and gold Returns on equity and gold are actual
Returns on debt are assumed to be 10% p.a., compounded annually For the purpose of calculation of returns from equity; movement in S&P BSE Sensex is tracked
(Source: ACE MF, World Gold Council, PersonalFN Research)

Suppose, you invested Rs 1 lakh on the last day of every year since 1993 to 2013 with a split of 70% in equity, 20% in debt and remaining 10% in gold, you would have made about Rs 77.88 lakh over 20 years without rebalancing the portfolio even for a single time. On the other hand with same investment amount you would have grown your portfolio to around Rs 92.28 lakh over similar time frame, if you had rebalanced it. For the purpose of rebalancing, PersonalFN earmarked the deviation of +/- 10% or thereabouts in the initial allocation. Whenever, equities rose to 80%, the portfolio was rebalanced. Similarly, when proportion of equities fell to 60% or below portfolio was rebalanced.

How frequently you should rebalance?
As given above, PersonalFN studied the impact of rebalancing. Portfolio was reviewed once in a year but rebalanced only occasionally. Over 20 year, portfolio was rebalanced 6 times. It is noteworthy that, it was not rebalanced from 1994 to 2001 even for a single time. It was first rebalanced in 2002 when proportion of equity dipped to about 60%. In the year 2003, equity markets generated spectacular returns of around 70% in a year. Equity markets kept trending up even through 2004 and 2005 which made PersonalFN rebalance the hypothetically created portfolio again in 2005, when proportion of equity went past 80%. Likewise, the portfolio was rebalanced in 2007, 2008, 2009 and 2011. In short, rebalancing helps when asset class generates extraordinary returns or makes extraordinary losses. Deviation in excess of 10% from the original allocation might be used as a simple test for rebalancing. However, it is noteworthy that you must review your portfolio atleast once in a year.

Other occasions when you should rebalance...
Apart from the factors mentioned above, there are a few more factors that may affect you decision of portfolio rebalancing. These factors are...

Change in the financial circumstances: Whenever your financial circumstances change; there is always a possibility that your risk profile may also change. Suppose, you got an excellent offer from a company paying you as much as twice of your current salary, you may want to invest more in equities.

Change in your financial goal: If you have any additional goal (One you didn't think of earlier) which is to be satisfied over a long term your portfolio might undergo a change. Similarly, if amount you thought you would need to fulfill your goal changes, your asset allocation may change.

Windfall Gains / losses: In both conditions, you may like to rebalance your portfolio. Windfall losses may reduce your risk appetite and also may make you work longer. As a result, you may want to put lesser money in equity and other risk assets. Vice-a-versa could be also true in case you make windfall gains.

Age is always a crucial factor: As you approach your retirement you should trim your exposure to risk assets such as equities and real estate. For example, you may have heavy exposure to real estate which could be trimmed before you retire in case rent receipts from such properties might be inadequate to generate regular income for you. It is also possible that, your exposure to fixed deposits and other debt investment avenues might be too low to generate adequate income for you post retirement. In such a case you must liquidate growth assets and increase exposure to debt. Gradual reduction in exposure to risk assets ensures any sudden change doesn't play a spoilsport. For example, those who were approaching retirement in 2007-08 and had higher exposure to equities would have generated far lesser profits had they not started reducing exposure to equities some years prior to their retirement.

Change in the outlook for a particular asset class: Although PersonalFN strictly recommends investors to follow goal based asset allocation; some of you might like to follow tactical asset allocation approach. This is one of the approaches followed while allocating assets. Under this, the portfolio is rebalanced depending on the outlook for various asset classes to take advantage of opportunities and generate superior returns.

So...Should you rebalance now?
Those who don't rebalance their portfolios at all or do only once in a while; may be interested in knowing what should they be doing under current market conditions. Besides, those following the tactical asset allocation approach might also want to know if they should increase exposure to any particular asset class.

After having witnessed stronger developed markets and weak emerging markets over 1 year, the trend is expected to reverse sooner or later. However, as far as India is concerned, growth has so far remained tepid. Whether it has bottomed out or we are still away from the bottom of economic cycle is uncertain. Capex cycle remains fractured with little interest of corporate to expand capacities. Higher inflation may limit the consumption growth. Higher interest rates are making it difficult for a large number of companies to control costs and maintain profitability. Under such a scenario markets have rallied from 17000 levels to 21,000 levels based on 4 factors;

  1. Weakness in the rupee during first 2 quarters of the current fiscal and marginal improvement in sentient in the U.S. and Europe drove earnings of Indian I.T. industry. Their heavyweight in Indian indices helped broader markets do well. The same holds true for some pharmaceutical companies.
  2. India is in a much comfortable position on Current Account Deficit (CAD) front at present than it was about 9 months ago. Rupee has been stable. This took off some pressure of the market.
  3. There is a hope that the new government will make efforts to turbocharge economic growth
  4. Sooner or later, corporate earnings may bottom out and they will rebound strongly once inflation and interest rates move down.

Factors mentioned above affect both, equity as well as debt which are the two most important asset classes for individual investors.

Given that markets are flat and have been awaiting results of Lok Sabha elections, you may like to cut down your exposure to smaller companies and move towards higher mid-caps provided you have a higher risk appetite. Although valuations in mid and small caps are cheaper than those in the large cap space; small caps and smaller mid-caps may experience extreme volatility if poll results are not as expected by the market. Let's not forget, earnings growth has been poor for smaller companies even in the December quarter. Similarly, investors should get rid of equity oriented mutual funds which have failed to generate market beating returns across time periods and market phases. These funds can be replaced with consistently performing funds offered by fund houses following sound investment processes.

On debt side, those who invest in company fixed deposits should revisit the portfolio as creditworthiness of many companies has deteriorated. There have been numerous instances of companies being unable to service their debt. Those who have exposure to long term debt funds may bring it back to 20% of their debt portfolio. PersonalFN is of the view that, one should not hold more than 20% of one's portfolio in long term debt. Short term debt funds look particularly attractive given the possibility of a cash crunch in the near future. Gold still remains attractive from the long term view point.

Many of you, who might be tempted to speculate on outcome of Lok Sabha election, might be considering equities attractive at this juncture. Markets were locked in upper circuit twice on May 19th, 2009 cheering the impressive victory of UPA in Lok Sabha elections. If you think markets will repeat the history even this time, you are running a risk of severely undermining the uncertainty in politics and unpredictability of the market. This is why PersonalFN refrains from speculation and follows goal based approach to asset allocation and rebalancing.

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