Personal finance: Investing in stocks — It’s time to rebalance your investment portfolio


The Indian stock market has provided significant returns since the low on March 23, 2020. Many analysts and investors are wondering why there is no correction in the market, and most believe the market is overvalued. However, in fiscal year 2021, the largest draw could be seen between February and April 2021 for around 8.5%. If investors are not comfortable with a future drawdown, then they need to rebalance their portfolio. Let’s discuss portfolio rebalancing in detail.

Why rebalance?
The primary rationale for portfolio rebalancing is to establish better risk control and to ensure that the portfolio is not overly dependent on the success or failure of any one investment, asset class or a particular type of fund. For example, suppose you invested Rs 10,000 in Company A and Rs 10,000 in Company B in January 2020. After one year, the total investment became Rs 40,000, and with the dividend, the total return is Rs 41,000. Due to market forces, the two companies may not operate equally. So, while company A gives you 17,000 rupees after a year, company B gives you 24,000 rupees. When you started your investment, both stocks had the same weight. After a year, one stock dominated your portfolio with a weighting of 60%. If this business performs poorly in the coming year, your investments will drop in no time. A rebalancing is therefore essential.

When to rebalance?
Investors could rebalance their portfolio according to the time strategy in which the portfolio is rebalanced quarterly or annually, regardless of the degree of deviation between the portfolio’s asset allocation and its original objective. Thus, determining how often to rebalance one’s portfolio depends on the investor’s risk tolerance, the costs associated with rebalancing, and so on. This is commonly referred to as time-based rebalancing.

Threshold based rebalancing
In this approach, investors first identify asset classes that deviate from the intended allocation using a tolerance threshold. Then, sell investments in the asset classes that exceed the planned allocation to align them. Then use the proceeds from this sale to invest in the asset classes that have fallen below the desired allocation. Let us understand the same with an example.

For example, your asset allocation plan includes a 10% investment in mid-cap companies. Twenty percent of this allowance is 2%. If you use a tolerance threshold, you rebalance when the mid-cap asset allocation goes below 8% or above 12%. In both cases, the asset class would have deviated from the planned 20% allocation. If an asset class was 50% of a portfolio, you would rebalance when that asset class fell below 40% or above 60%.

Major advantage
When the market goes down, investors tend to sell their holdings before conditions worsen. Being essentially forced to sell high and buy low is one of the most important benefits of maintaining a balanced portfolio over time. Building a balanced portfolio and taking steps to maintain it can help investors avoid relying too heavily on their emotions when making important investment decisions.

In conclusion, when implementing portfolio rebalancing, investors should consider the associated costs and tax implications. Empirical studies indicate that annual rebalancing offers better risk-adjusted returns with reduced rebalancing cost.

Balancing the Odds
— If investors are not comfortable with a future drawdown, they should rebalance their portfolio
— The main rationale for rebalancing the portfolio is to establish better risk control and to ensure that the portfolio is not overly dependent
the success or failure of a particular investment, asset class or fund type
— When implementing portfolio rebalancing, investors should consider the associated costs and tax implications

The author is Professor of Finance and Accounting, IIM Tiruchirappalli

Previous Valkyrie Digital Assets LLC Launches Valkyrie Zilliqa Trust, Sixth Investment Vehicle
Next What is a balanced investment portfolio?