Picture yourself on a 6-day trek in the Himalayas. You are at the second camp, on your own, and you still have four days of trekking ahead of you. You’ve got your equipment, food, a map, a compass, and a spirit of adventure. You’ve chalked out the plan, but something unexpected happens on Day 3. You realise that you hadn’t checked your compass for the first few hours. Due to which, you find yourself heading in the opposite direction of where you should be headed. There’s no water source where you are, so you can’t even stay put until the next day. Now what?
I’m sure you’re wondering, “What does a trek and a compass have to do with portfolio rebalancing?” Bear with me.
Suppose your investment plan requires a certain asset allocation in equity and fixed income. You might start off investing in your desired ratio, but the market fluctuates on a regular basis. A sharp rise or a dramatic fall would skew this ratio either way. Rebalancing your portfolio helps you stay on course, just as a compass does.
Today we explore the what, why, how and when of this crucial, yet often overlooked exercise.
What is Portfolio Rebalancing?
Portfolio rebalancing is the process of restructuring your investment plan by investing or divesting funds in such a way that you maintain your desired asset allocation.
A Little Background
When you formulate an investment strategy for yourself, you consider factors such as your age, goals, and risk appetite. Once you’ve decided on your asset allocation, execution mode turns on. You start a few SIPs, invest in a few stocks and fixed income instruments, sit back, and watch your portfolio grow. That’s when inertia can set it. While there is no need to check your portfolio every day, a periodic review is essential to know if your execution is aligning with your plan.
For instance, if your asset mix is 70% equity and 30% fixed income for the foreseeable future, you want to be sure that this mix doesn’t change too much.
Let’s say you invested a total of ₹1,00,000 in 2020. Of this, you invested ₹70,000 in equity shares and equity mutual funds, when the stock market was low. The balance ₹30,000 you invested in debt mutual funds. What is your asset mix today, in 2022, when the stock market is high?
The equity component could be worth ₹1,40,000, whereas the fixed income component might just be worth ₹35,000. Working out your asset allocation now, we get 80% equity and 20% fixed income. Assuming the market continues to rise, this ratio will continue to lean toward equity heavily.
On the other hand, what if you invested when the market was high, and it is now on a downward trajectory? A ₹70,000 investment in equity could be worth ₹35,000 now, with a fixed income investment of ₹30,000 being worth ₹35,000. The ratio of 70:30 changes to 50:50.
The Power and Process of Portfolio Rebalancing
You’re probably thinking that if the market keeps fluctuating like this, what use is rebalancing one’s portfolio? Is it really that important? And how does it work?
Research has shown that investors who adopt the process of portfolio rebalancing, are able to maximize their returns, earning anywhere between 1-5% higher than what they would have earned without it. Seems like a small percentage, but returns aren’t the only reason. We can eliminate our emotional biases and be level-headed about our investments. Here’s how.
Firstly, fixed income goes up steadily. With equity, there are numerous ups and downs. While the rise in equity is at a much faster pace than fixed income, it is erratic.
Secondly, it’s usually when the market is doing exceedingly well that investors confidently take the plunge with equity. When the market falls, most investors panic and sell, incurring huge losses. When we do this, we are acting on our emotions. Portfolio rebalancing is a strategy you can use to avoid succumbing to your emotions.
When the market is high, rebalancing encourages you to take advantage of sizeable gains in equity by cashing in and reinvesting the proceeds into fixed income. More importantly, rebalancing ensures that you are not over-exposed to a riskier asset class, one that could plummet without warning.
In times of a market crash, rebalancing forces you to redeem part of your fixed income investments and reinvest it into equity. Using this strategy, you would automatically be selling high, and buying low.
How Often Should One do this Exercise?
Keep it simple. Remember the compass. You only have to course-correct when you’re headed in the wrong direction. Checking your asset allocation ratio annually is an ideal frequency for this exercise. Generally speaking, the last quarter of the financial year is a good time.
Alternatively, you may also set a range beyond which you can rebalance. For example, if my range is 10%, I will only rebalance my portfolio if the equity portion is out of whack by 10% or more in either direction. This range will vary from investor to investor. It all depends on the factors that determine your asset allocation strategy.
Doing this exercise too often, however, would not be wise. You will incur costs in the form of exit loads, brokerage, and capital gains tax.
What are the Tax Implications?
Until a few years ago, gains made on selling equity investments were tax-free. Under the current tax rules, gains exceeding ₹1,00,000 are taxable. Gains made on selling debt mutual funds (fixed income asset class), are also taxable. So, it’s essential to plan the rebalancing activity keeping taxation in mind. This article will help you understand the tax aspect better.
It’s interesting to note that if you’re investing in a balanced mutual fund, the fund manager is responsible for the portfolio rebalancing activity. When balancing is part of the scheme itself, we, as investors, do not incur any tax.
Moreover, buying and selling isn’t the only way to rebalance your portfolio. You could also direct incremental investments to the appropriate asset class such that your asset allocation ratio remains intact. This lets you bypass capital gains tax.
Check that Compass
Let’s come back to that Himalayan trek you were on. You were headed off in the opposite direction of your next campsite. What do you do? It’s easy to fret and fume. What’s harder and what will yield a better outcome, is staying calm, trusting the compass, and rerouting your steps.
Portfolio rebalancing is just the same. Market fluctuations can throw you off course. Sometimes marginally, sometimes drastically. But with rebalancing in your investment toolkit, you will be able to keep your cool, conquer your emotions, review your asset allocation ratio, and take necessary action; action that guarantees a robust and rewarding portfolio.
