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Investing 101:

Rebalancing Your Investment Portfolio

Your prime strategy in investing should not only be diversification of your investment in accordance with your investment strategy, but also rebalancing your investments in accordance with your target asset allocation. When you invest, you do so optimally in different asset classes, allocating a certain percentage for each of the assets. This asset allocation is done in accordance with your investment strategy which is developed on the basis of your financial situation, risk/ return objectives, risk tolerance level, and holding power. After you have decided on your asset allocation, then you need to fine tune it with the passage of time. This is called rebalancing of your investment portfolio.

Rebalancing is necessary to make sure that your investment portfolio is in keeping with your target asset allocation which has already been devised on the basis of your investment strategy. Suppose you have Rs 1 Mn, of which you have invested Rs 0.7 Mn in stocks and Rs 0.3 Mn in bonds. After a period of 5 years, your stocks have grown really well, but your bonds have remained stagnant. So what started off as an asset allocation of 70% stocks and 30% bonds shifted to 80% stocks and 20% bonds. This is referred to as ‘Portfolio Drift’ in investor-speak.

Now you might want to correct this portfolio drift by rebalancing your portfolio. You can do so by selling off some of the stocks and investing that money in bonds to return the portfolio to your desired asset allocation/ target asset allocation of 70% stocks and 30% bonds.

However, your target asset allocation may not necessarily be kept at the above configuration. With the passage of time, you might want to shift the target asset allocation to another configuration of your desire. For example, you might want to keep your investment portfolio as 80% stocks and 20% bonds or have any other configuration of your suitability. But whatever the configuration of your investment portfolio, you would want to rebalance your portfolio to avoid the portfolio drift that can occur over a period of time.

But the question you might want to ask is why rebalance the portfolio? Why not let the assets that have gained in value continue growing, and not rebalance the investment portfolio? The simple answer to this question is: What goes up must come down. While this is just a phrase of speech, it reflects well on the capital market. A rising market is a good time to sell off some of your assets. This will provide you an opportunity to realise gains from your investments while the market is at higher levels. Conversely, this will allow you to re-enter the market and re-invest to rebalance your portfolio when the market takes a dip again. This rebalancing has allowed you to sell high and buy low, thereby turning your investment strategy into a successful one.

Apart from selling high and buying low, another opportunity that rebalancing provides is that it protects the investors from being over-exposed in the market. An ignored portfolio often sees the assets bloat up, vulnerable to a market crash. This is specially true of stocks and the stock market. When you sell some of your over-valued stocks at a crest of the market, you are avoiding the possibility of being stuck in a rut when/ if the market crashes.

There are, however, some downsides to rebalancing. Every time you buy or sell a stock, mutual fund, ETF, or any other type of security, you are incurring charges such as commissions, taxes, entry & exit load fees (mutual funds). So this might be a drawback for you, if you rebalance too often or too regularly.

To get maximum advantage of rebalancing, you may want to do so periodically at certain instances of the market movement. If, for example, the portfolio drift is such that the stocks attain 72% weightage (from the initial 70% weightage) in the investment portfolio, then it is not necessary to rebalance at that time. Perhaps it would be better to wait out and ride the market wave till the portfolio drift is substantial enough to warrant a rebalancing. For example, if you set a threshold of 10% and your target asset allocation is 70% stocks and 30% bonds. So when the portfolio drift reaches 80% or 60% stocks, then you may want to rebalance, regardless of when you had last rebalanced your portfolio.

You may also set a certain time interval to rebalance your portfolio. For example, a period of three months or six months may be a good interval of time to rebalance. This will allow you to avoid the recurring charges incurred on too much rebalancing and at the same time will protect your portfolio from getting inflated or over-valued.

Another way to rebalance is to do so through buying only, instead of selling off assets. For example, if your target allocation of 70% stocks and 30% bonds has drifted to 75% stocks and 25% bonds, then instead of selling stocks, you invest in bonds and keep doing so until your target asset allocation is aligned back to 70% stocks and 30% bonds. You can do the same with dividends as well, whereas the dividends earned can be re-invested and thus assets can be bought to rebalance the portfolio. This way you can do rupee cost averaging against your investment when buying the said assets at different rates.

It is pertinent to mention that the closer you get to retirement, the more the attention should be paid to asset allocation and rebalancing. When you’re younger, you can afford to take your time in rebalancing your investment portfolio as you can sustain hits when the market suffers a crash or a major down-trend.

Conclusively, there are several methods to rebalancing your investment portfolio, of which you can use an individual method or a combination thereof, and you may rebalance based on the time interval or gap suitable to you.