An investor can avoid all sorts of financial mistakes: Chasing trendy funds/stocks, not matching your investments to your goals, paying too much for advice, not diversifying enough. But if you fail to rebalance: making necessary adjustments after monitoring and reviewing your portfolio periodically and, you will only have limited success as an investor.
Why should you consider rebalancing? Knowing when to rebalance
Knowing when to rebalance is as important as the act of rebalancing itself.
1. To restore the mix that you determined was right for your goals. Check if your portfolio has drifted from the original asset mix: cash, bonds, and stocks; its mix of investment styles and sectors and country exposure; and its concentration in individual stocks.
2. Periods of market volatility maybe a good time to review and adjust your portfolio.
3. Financial goals are bound to change over time for most individuals, owing to change in job, marriage etc. Your current mix of stocks, bonds and cash (portfolio) needs to be adjusted to reflect your new financial goals.
Let’s understand this with a simple example. Ram has conducted his research and with the help of an advisor determined his ideal investment mix should be: 60% equities and 40% Bonds. This is keeping in mind his return expectations and risk-taking ability.
Initial Portfolio Asset Mix
Let’s assume, over the next 5 years the Equity markets shot up owing to which his asset mix changed. Now, why should that matter?
Portfolio Asset Mix - After the equity markets shot up
It does! Yes, Ram’s portfolio has performed well as equities have done well. But keep in mind: now an additional 8% of his portfolio is exposed to greater risk. This might not be suitable for Ram’s risk return profile.
Because equities tend to be the riskiest of these three asset types, the increased exposure could leave Ram exposed to more risk than he’s comfortable with.
Re-balancing is tricky and difficult to implement, but essential
It is a process where you have to sell off the investments that have performed well and attribute it to those that haven’t.
Continuing with our above example: Ram will have to sell off a portion of his well-performing equity investments. He will then have to invest that in the relatively lower performing asset class of Bonds to go back to his initial Portfolio asset mix of 60/40.
Where should you start?
Before actually rebalancing you need to determine what is out of balance. Start by reviewing your portfolio periodically. The rule of thumb is to monitor your portfolio on an annual basis.
Check your portfolio’s asset mix: the % of your portfolio that is devoted to the following:
4. Investment Styles
The most important aspect of rebalancing is your asset mix. It is defined by your return expectations and your risk tolerating ability. A portfolio can be made conservative or aggressive by adjusting the amount invested in stocks versus bonds. Note that leaning more towards stocks will increase your portfolio’s long-term return potential but will also increase short-term volatility.
For a steadier performance, an investor should allocate more towards bonds.
Apart from asset mix one must also review their holdings within the asset. For e.g., if you invest more in short-term bond funds with higher credit quality it will stabilise your bond portfolio’s performance and make it conservative. But the trade-off for greater stability will be lower returns.
On the other hand, you can take higher risks and get more aggressive by investing in long-term or even lower credit quality Bonds.
Similarly, reviewing your stock holdings is a must. If you feel your stock portfolio is way too volatile and risky invest more in bigger companies (large and mid caps) or companies that pay dividends or the ones that are available at reasonable valuations.
Don’t ignore the single sector exposure risk: be mindful of your exposure to a single sector. Incase it has changed owing to varying levels of performance in different sectors. It can be in the form of stocks or even bonds. You might enjoy higher returns focusing on 1-2 sectors temporarily but it also exposes you to risk of poor performance in a single sector.
Had your portfolio been more exposed to the telecom or auto sectors in the past 1.5 years it wouldn’t have even matched the benchmark (BSE-SENSEX) returns.
Investing would have been a lot easier if we were a part of a fairly stable and predictable market. But change is the only constant. And we live in a world where the unforeseeable global events now affect us as well as the financial markets. The best way to ensure that we emerge as a successful investor is to set a financial goal early in life and stick to it. Review your portfolio annually atleast and make necessary adjustments so they reflect our long-term financial goals. Do a quick quarterly review. It will help you prepare for the year-end changes.