Investing smarter: it’s time to rebalance your investment portfolio


The strong performance of equity markets in 2021 has driven many investors away from their target portfolio allocations. It’s time to make sure the portfolio allocation stays within their risk tolerance

After a year of double-digit stock returns, it may be time to rebalance your portfolio. This will ensure that you don’t deviate from your long-term investment plan. It’s a good idea to do a detailed analysis of your portfolio at the end of the year or at the beginning of the calendar year. Let us discuss the process in detail.

Why is rebalancing necessary?
Typically, equities are the most widely used asset class for capital growth, while fixed income securities are often reserved for the primary purpose of capital preservation. The strong performance of equity markets in 2021 has most likely driven many investors away from their target portfolio allocations.

The objective of allocation is to balance various risks while working towards long-term goals by targeting a certain percentage of your portfolio to invest in various asset classes, primarily equities and fixed income securities. In a year when equities are outperforming fixed income, portfolio rebalancing is essential to shift some of the wealth created from the equity side of the portfolio to the fixed income side of the portfolio to preserve newly created wealth.

How is the asset mix changing?
Consider an example where the portfolio is 60% equities and 40% fixed income. Again, within stocks you have 35% large caps, 17% mid caps and 8% small caps. Assume that large, mid and small caps grew by 43%, 70% and 103% respectively over the last year. So your target asset allocation would have gone from a 60/40 mix of equities and fixed income to 69% equities (36% large caps + 21% mid caps + 12% small caps ) and 31% debt securities.

To return to the 60-40% targeted asset allocation, you need to use the technique of portfolio rebalancing, which means you need to sell some of the stocks and invest more in fixed income securities.

Benefits of portfolio rebalancing
Typically, investors choose their portfolio to have a pre-determined asset allocation based on their financial goals with an appropriate level of risk. As markets fluctuate, weightings may stray from their initial preferences. Generally, over the long term, stocks tend to perform better than bonds. And if no rebalancing is done periodically, there is a higher probability that the portfolio will start to be more equity-oriented. Thus, it may expose investors to additional risk during periods of volatility, with the possibility of greater future losses.

So rebalancing brings the portfolio back to your original asset allocation. This can be done in two steps. In the first step, determine the total investment in the target ratio, then calculate which asset class should be bought and sold and at what price.

In conclusion, it is essential for an investor to ensure that the portfolio allocation remains within their risk tolerance and rebalancing should be done periodically, at least once a year to ensure that market performance does not not take portfolio allocations too far from their objectives.

P Saravanan is Professor of Finance and Accounting at IIM Tiruchirappalli

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