Financial planning: Why you need to rebalance your investment portfolio

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Published: September 3, 2019 2:17:15 AM

Rebalancing works as a risk minimisation strategy, allowing the investor to periodically line up investments in alignment with their goals

investment planning, investment planning takes steps to, investment planning process, investment planning india, investment planning calculatorDuring volatile markets, the tolerance band method could be more expensive than periodic rebalancing because you could be buying and selling more frequently and leading to more trading costs

The bull run in the stock market that recently ended has left many investors with an interesting problem: A lot of
unrealised profit in shares and mutual funds. If a significant portion of your investment is in shares, it might exceed your risk tolerance. So, the solution is to rebalance your portfolio to a comfortable level. Let us discuss why and how to rebalance your portfolio.

Why you should rebalance?
A good investment portfolio is diversified among different types of investments known as asset classes. These include shares, mutual funds, bonds, bank fixed deposits, cash, real estate, etc. It is good to diversify within each asset class. For instance, the average investor prefers to own only IT stocks. The safer bet would be to own a mix of diversified stocks across many different sectors.

If you have already invested in mutual funds or ETFs, you already benefit from diversification to some extent. The primary objective of portfolio rebalancing is to establish a better risk control, ensure that your portfolio is not heavily dependent on the success or failure of a particular investment, asset class, or fund type.

Periodic rebalancing
There are two main strategies suggested in investment science literature. First one is known as periodic rebalancing. This method requires little effort, one should ideally check the investments every six months to see if these need rebalancing, but consider doing so at least annually. For instance, make it a point to check them the week after you submit your tax returns, when you are already focused on your financial picture. Then set a reminder to evaluate your portfolio again six months later. Even if you are a passive investor who simply follows buy and hold strategy, you should rebalance your portfolio at least once a year.

Tolerance band rebalancing
This method also helps rebalance the portfolio to align with your intended asset allocation, but is based on a percentage change in your allocation. More frequent monitoring is needed for this method than with the periodic rebalancing approach. For instance, if you chose 7% as your threshold of change and your target allocation of shares was 57% of your portfolio, you would rebalance if your portfolio shifted to 55% stocks in a rising market, or 43% in a declining market.

Setting a specific threshold at which you rebalance could help you make considered investment decisions even in a rapidly changing market. However, during volatile markets, the tolerance band method could be more expensive than periodic rebalancing because you could be buying and selling more frequently and leading to more trading costs. The costs will vary, however, based on the composition of your portfolio.

Although literature suggests two strategies, no particular investment methodology can guarantee success, but both approaches can be effective. The important thing is not how to rebalance the portfolio but picking a method and sticking to it.

To conclude, rebalancing actually works as a risk minimisation strategy for the investor. It allows one to line up investment in alignment with their goals by periodically rebalancing the portfolio. Whenever the risk tolerance or your investment strategies change, you could re-adjust the weight of the asset class in your portfolio by rebalancing and devising a new asset allocation.

(The writer is a professor of finance & accounting, IIM Tiruchirappalli)

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