In the journey of financial goal accomplishment, it’s required to have periodical reviews of one’s financial portfolio.
By Kumar Gaurav & Pallavi Seth
As an investor, we always carry our wish list of liquidity, tax advantage, inflation beating and guaranteed returns but the reality is there is no perfect asset class that will carry all benefits. And therefore, we design an asset allocation plan to fulfil our financial goals perfectly. There is a tendency to get over-exposed in one asset class and underexposed to others on the basis of our greed and fear. Controlling these emotional biases is critical in making a well-diversified portfolio.
What is rebalancing?
In the journey of financial goal accomplishment, it’s required to have periodical reviews of one’s financial portfolio. Rebalancing is used as a tool to get on track whenever one deviates from his set asset allocation plan. Across the globe, a 60:40 (equity: debt) is followed in an asset allocation plan. Post Covid-19, equity as an asset class has seen a unilateral north move and currently we are at the till-date peak of markets. The current market cap-to-GDP ratio is standing at 188% which speaks of markets being overpriced (market cap to GDP ratio is a buffet indicator to judge whether the valuation of the markets are fairly priced, overvalued or undervalued). A rebalancing act is required to bring the off-track portfolio within our set strategy of asset allocation.
For example, let’s say Raj had invested `1 lakh in the ratio of 60:40 in equity and debt mutual funds last year. The equity component was further divided into large, mid and small funds and some portion into sector bets. Equity portfolio surged by 40% and debt generated 5% return. Now, the ratio is `84000: `42000 (equity: debt), i.e., 66:34. So a rebalancing tool is used to come back to the original ratio of 60:40.So, some equity funds are sold to purchase units of debt funds. Even the investors with lesser risk appetite may think of tweaking the equity debt ratio as per their requirements.
Basis age of the investor: Financial planners advise to allocate (100-age) percentage into equity. This belief is based on the premise that an older person should take less risk than one of lower age. So, at different age intervals the portfolio is rebalanced.
Basis market valuations: Markets are driven by fundamentals, liquidity and sentiments. When fundamentals are right, liquidity is surplus and sentiment is one of euphoria, the market makes new highs. And our asset allocation plan gets off track. Rebalancing is used to get within the set limits.
Return target achievements: Let’s understand this by an example. Say one has a plan to travel to Chandigarh and the estimated time of travel is seven hours. One started early in the morning and reached in five hours.
So, since the person saved two hours, should he continue travelling and reach Shimla? At the inception of an investment, one sets the return target and after accomplishment of the targets, one should rebalance one’s portfolio.
Balanced advantage funds in equity category and asset allocated funds in debt category are examples of funds using rebalancing techniques. Almost all asset management companies have this category of funds. The fund managers of these funds tweak their equity, debt and gold components as per their models of market valuation. The current market conditions definitely require a review of existing portfolios and taking corrective measures wherever required.
Kumar Gaurav is managing partner, Nurturing Wealth & Pallavi Seth is faculty, Amity School of Insurance, Banking and Actuarial Science, Amity University