Now that you have set up a robust portfolio, you begin to plan your journey towards your investment goals. With a disciplined approach, you follow a desired asset allocation (blend of stocks and bonds) that best matches your risk profile. But, what you did not anticipate is market volatility! Since markets tend to fluctuate without warning, it can cause your portfolio to veer off track. This is when you need to fit in a strategy to get it back on schedule. The entire process of doing so is called rebalancing.
What is portfolio rebalancing?
The process of realigning your portfolio back to target asset allocation, by buying and selling a portion of your portfolio is referred to as portfolio rebalancing.
For example, you decide to invest in equity and bond equally. A year later, the equity market outperforms and you put more money in equity investment. This change may seem like a good strategy on paper but in reality, your portfolio is exposed to greater risk than before.
The concept of rebalancing goes way deeper than just sticking to the original asset allocation. Rebalancing is a complex exercise and a number of factors need to be taken into consideration, such as age, income level and investment requirement. Your target asset allocation may also need to change as you age and your growing needs. The change in target asset mix also calls for rebalancing.
For example, with age you may want to shift from an aggressive asset allocation strategy to a conservative asset allocation strategy. Let’s say, you are currently at pre-set asset allocation of 70% equity and 30% bonds, which has a higher exposure to risk. As you age and get closer to your retirement years, you may want to play safer with your investment, for example move to an asset mix of 40:60 equity and debt. Given your risk appetite, you may need to relook at your portfolio accordingly.
Why do you need to rebalance?
- For active risk management
When the market is on a roll, a larger stock investment may seem good. But, when the market drops unexpectedly, you are exposed to a higher risk of price drop. Thus, rebalancing your portfolio on a timely basis can help keep the risk balanced.
- To realign your portfolio based on your investment goals and needs
Your life circumstances, overall goal and risk level tend to change over time, which calls for a rethink on your asset mix and portfolio rebalancing. The asset mix that worked for you 10 years ago, may not be appropriate for at the moment, when you maybe only a few years away from your goal.
Type of portfolio rebalancing strategies
- Tactical rebalancing: This particular strategy is applied based on external events and market environment. Basically, it is suitable for active investors who keenly follow the market.
- Periodic rebalancing: A systematic application of periodic rebalancing is helpful in reviewing the portfolio on regular basis and can be rebalanced if necessary. You can define a percentage of deviation to trigger rebalancing. For example, your original asset allocation is 60% equity and 40% debt with a deviation of 5%. Rebalancing will trigger only when the equity exposure shoots up to 65% or comes below 55%.
A well-diversified portfolio includes various assets (stocks, bonds, gold and cash etc.) with different risk and return characteristics. A diversified portfolio also includes assets with differing correlation that do not move in the same direction during change in market condition. Thus, rebalancing a portfolio allows investors to capture the gain during market volatility with these uncorrelated assets. For example, gold and equity have an inverse relationship. When gold prices rise, stock prices tend to go down and vice versa. Thus, it is important to look at the market condition while rebalancing your portfolio..
Rebalancing may also involve costs such as tax and other transaction fees. Hence, rebalancing is a complex process that depends on various other factors like fluctuating market conditions, shift in financial circumstances, lifestyle changes and costs involved. Seeking expert help can benefit in managing risk professionally along with generating returns for your desired goal.
Portfolio rebalancing will depend on your risk/return profile. Ultimately, it is an important risk control tool that will help you to stick to your investment plan and goals regardless of market conditions changes.