- What is portfolio rebalancing?
- Why is portfolio rebalancing important?
- What happens if you don't rebalance your portfolio?
- How often should you rebalance your portfolio?
- Who can rebalance my portfolio for me?
What is portfolio rebalancing?
Imagine you're packing a suitcase for a trip. When packing a suitcase, you need to decide what clothes, shoes, and other items you want to bring with you.
You might want to bring some shorts for hot weather, some sweaters for cold weather, and some comfortable walking shoes. You'll also need to think about the size and weight of your suitcase and make sure you don't pack too much or too little.
On your way to the destination you find out that there's going to be a snowstorm, so you'll need a big, thick winter coat. But you can't carry a new bag so you need to make room for the coat in the same one. You get rid of a few non-winter clothes to include the coat. Now your bag has more utitility value as it will improve your experience once you reach your destination.
Rebalancing is a strategy that involves periodically reviewing and adjusting the mix of investments in your portfolio. This is to ensure it remains aligned with your financial goals, risk tolerance and market conditions that are always changing.
This process involves buying and selling different assets in order to maintain the desired allocation of asset classes, such as stocks, bonds, and cash.
"The only thing that is constant is change." - Heraclitus
In the world of investing, market conditions and an investor's personal financial situation can change over time. This is why portfolio rebalancing is essential.
Why is portfolio rebalancing important?
Let's assume your portfolio has an asset mix of 7:2:1 in favour of equity, debt and gold respectively.
Suppose, you invested Rs 1 lakh on the last day of every year from 1993 to 2013 with this asset split.
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 the same investment amount you would have grown your portfolio to around Rs 92.28 lakh if you had rebalanced it.
(The rebalancing is assumed to be +/-10% in the initial allocation based on evolving market conditions favouring a particular asset class.)
Rebalancing your portfolio has several benefits.
- Rebalancing helps manage risk.
- Rebalancing can improve portfolio performance.
- Rebalancing ensures the portfolio is diversified and aligned with your investment strategy.
- It can help you adapt to market conditions and personal financial situations.
This is assuming changes over a long period of time. In order to see what portfolio balancing looks like in the short term, consider this example.
Example: Amit decides to invest 50% in a bond fund, 10% in a P2P investment, and 40% in an equity fund.
At the end of the year, Amit finds that the equity portion of his portfolio has grown more than the bond and P2P investments.
This has changed the allocation of assets, increasing the percentage in the equity fund and decreasing the amount in the P2P and bond funds.
The equity fund grew 37%, while the bond fund lost 5% and the P2P investment gained 4%. The overall return on Amit's portfolio was 12.9%, but now there is more in equities than bonds.
Amit might leave the asset mix as it is for now, but leaving it too long could mean an increased risk with too much in the equity fund.
What happens if you don't rebalance your portfolio?
Portfolio rebalancing helps you maintain the trade-off between risk tolerance and the growth potential of your portfolio.
Say you’re more risk-averse and prefer to hold a higher proportion of bonds. If you don’t rebalance, you could expose yourself to more risk than you’re comfortable with if the equity portion of your portfolio grows.
On the other hand, failing to rebalance could mean you’re not taking enough risk to achieve your investment goals. You could end up with too much of your money in bonds or fixed-income investments, which could limit your portfolio’s growth potential.
Example: Retirement funds during the accumulation phase may have a larger allocation to equity, which requires to be rebalanced with debt during the consolidation or withdrawal phase.
How often should you rebalance your portfolio?
There's no one-size-fits-all answer to how often you should rebalance your portfolio. Some investors review their investments every year, every quarter, or even every month.
Others wait until an asset allocation drifts beyond a certain point, like 5%, before making changes. Ultimately, it's up to you to decide how often you want to review your portfolio based on your personal goals and risk tolerance.
But there are different techniques used to rebalance a portfolio. Some depend on market conditions and some more on personal investing styles.
- Calendar rebalancing is common and adjusts investments at on a periodic fixed date, but doesn't consider market movements.
- Constant-mix rebalancing is also common and sets target weights and tolerance ranges for each asset class, rebalancing when any holding moves outside its range. For example, 7:2:1 with equity, debt & gold respectively.
- Constant Proportion Portfolio Insurance makes sure if the value of your investment starts to drop too much, it will help you move some of your money back into the safe place to make sure you don't lose it all.
- Smart beta rebalancing follows a set of rules to allocate holdings and is more active than index investing but less so than stock picking.
Who can rebalance my portfolio for me?
Simple answer? An expert.
- Financial advisors can help you rebalance your investment portfolio as part of a long-term financial plan.
- Portfolio managers can also manage your investment portfolio and help you rebalance it.
- Robo-advisors are online platforms that use algorithms to create and manage your investment portfolio, including rebalancing it.
It's generally a good idea to seek the advice of a financial professional before making significant changes to your investment portfolio.
Every retail investor is burdened with researching when they try to rebalance their investment portfolio and financial advice can be expensive.
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