When the allocation level of any asset class is breached, it should lead to rebalancing. Follow this rule without exceptions and you will definitely earn better returns.
By Raj Khosla
The Covid-19 pandemic has demonstrated how volatile equities can be. The benchmark indices have moved up and down like roller coasters during the past three months, even as investor sentiment has toggled between elation and consternation. One day it looks like the bears have an upper hand. The very next day the bulls come back with a vengeance. Investors are confused whether they should buy, sell or just sit tight.
Actually, investors should do all three depending on how their portfolio has performed. Though you cannot control volatility, you can control the risk in your portfolio through prudent asset allocation. They should just rebalance their portfolios to restore the asset allocation mix they had decided for their investments. Back-testing studies have shown that investors who regularly rebalance their portfolios and stick to a predetermined asset allocation tend to do better than investors who keep their portfolios static and let them flow with the market.
Rebalance the portfolio
Every investor knows that asset classes do not move in the same direction or at the same pace. This differential growth changes the complexion of the portfolio mix over time. If equities are assumed to rise 15%, debt gives 7% and gold moves up 5% per year, in just six years a portfolio that has allocated 60% to equities, 35% to debt and 5% to gold will have more than 70% in equities. This is not a problem if the equity market continues to rise at an even pace. But the portfolio will see a more pronounced decline if stock markets tank. Besides, an investor who was willing to put in only 60% in equities 10 years ago should logically allocate less to this volatile class as he grows older.
Obviously, an investor cannot rebalance the portfolio very often. It is recommended that the rebalancing exercise is undertaken at least once a year. This should preferably be at the fag end of the financial year or the beginning of a new one when you ought to book capital gains or losses.
It is also advisable to rebalance in case of a major market development, where a particular asset class moves up or down by more than 15-20%. A perfect example is the Covid-induced crash in March this year when the Nifty briefly fell below 8000. Disciplined investors who rebalanced their portfolios in March would be sitting on a neat gain of 20-25% in their equity investments.
Asset allocation of the portfolio
By restoring the asset allocation of the portfolio, rebalancing helps control the risk in the investments. This, in turn, helps in boosting the investor’s confidence. When the markets tumble, a rebalanced investor is less likely to panic and more likely to remain invested.
Despite its advantages, the rebalancing exercise is seldom carried out by small investors. The decision is a contrarian call, where the investor is expected to sell assets that have performed well and instead invest more in underperformers. Nobody wants to cut the flowers and water the weeds. When the Nifty rose above 12400 earlier this year, very few investors thought of booking profits in stocks. But selling some of their holdings at that point would have somewhat cushioned them against the big decline in March.
This underlines the role played by a financial advisor. Egged by greed during a bull run and overwhelmed by fear in a down market, retail investors often get carried away by emotions. They are not able to take the right decisions and usually end up losing money. On the other hand, a qualified financial advisor is able to see things dispassionately and provide the right guidance. If you don’t have a financial advisor, make sure you stick to your predetermined asset allocation. When the allocation level of any asset class is breached, it should lead to rebalancing. Follow this rule without exceptions and you will definitely earn better returns.
The writer is managing director, MyMoneyMantra.com