What is Portfolio Re-balancing and Why it is most important in Investing?
What is portfolio Rebalancing and why it is most important in Investing?
As an investor, everyone should have an asset allocation. We have discussed about this in detail at the start of this investment series.
In short, considering we are investing for long-term goals which is at least 10 years away,
· If you are a safe investor, you should have a reasonable exposure towards equity, say 50–60%
· If you are a risky investor, you should have high exposure towards equity, say 75–80%
That is some basic, raw asset allocation and you should structure your investment in such a way that it is as per the planned asset allocation.
But if market crashes or rallies, you asset allocation will go for a toss. This is where rebalancing will come into picture.
So, why is Rebalancing important for every investor?
The objective of portfolio rebalancing is to ensure that your portfolio isn’t singularly dependent on the success or failure of a particular investment, asset class, or fund type.
Let’s take an example:
Let’s assume that you invested Rs 40,000 per month in equity mutual funds and Rs 10,000 in EPF/PPF. It is being done by keeping in mind 80–20 asset allocation. (i.e) Your asset allocation is composed of 80% equity and 20% debt component.
So, yearly you are investing 4.8L in MFs & 1.2L in PFs. You repeat this for 10 years.
At the end of 10 years, your investment of Rs 48L in equity MF doubles up and turns into Rs 1.12C considering 15% annualized returns. Likewise, your 12L in PFs will turn into 18L considering 8% annualized returns.
When you began your investment, asset allocation was 80–20, but after 10 years, your portfolio had grown to 1.1C and in the process your asset allocation has changed to 86% equity and 14% debt.
In the coming years, if equity continues to perform well, then your equity allocation can hit 90% mark as well. This is risky for any investor as their portfolio is dominated by single asset class, which is equity mutual funds. If stock market crashes and halves, their portfolio will also be halved, which is extremely dangerous. In order to avoid this, it is best for the investor to rebalance the portfolio regularly.
We can either do a time based rebalancing (like every year or every alternate year) or we can do % based rebalancing (like if the portfolio deviates by a certain %, say 5% from planned asset allocation, we can rebalance it).
What should be done during rebalancing?
It is simple, for the above example, we just have to sell some equity mutual funds and invest that amount in debt component. As simple as that.
So how much equity MF I should sell?
We should sell equity MF for the amount, which would reduce the asset allocation of equities and bring it back to 80. So, for our case, we need to sell 8L worth of equity mutual funds and reinvest the amount in debt.
This will reduce the equity holdings to 1.04C & increase the debt holdings to 26L and will bring the asset allocation back to 80–20.
And remember the following items,
· Whatever I mentioned here is just an example. We should not wait till 10 years to do this. This should be done periodically or regularly, say at least every couple of years.
· While doing rebalancing, keep the tax aspect in mind and sell the units which gives us maximum tax benefits.
· Our asset allocation will go for a toss when market crashes as well and in that call, we need to sell some of our debt holdings and invest it into equity. This is the other half of rebalancing.
· We need to do this at each asset classes — like equity, debt, gold & RE and also at each sub asset class level we discussed earlier, like in equity mf, large cap, mid cap, flexi cap, etc
· I have explained in the initial asset allocation video on how this will help us to buy on the dips and market crashes and how it will help us to sell our holdings on the market peaks. So keep that in mind as well. I’ll leave the link to that video in the description section of this video as well.
For more details and examples, checkout: