Take the example of three individuals, Ravi, Manish and Sheena.
Ravi, who is now 35, started his investment journey very early at the age of 24. At that time, he was earning very little and also had to repay his student loan. As a result, its ability to take risks was very low and thus approximately 30% of its investments were in equity instruments and 40% of its investments were in debt securities. He paid off his education loan at the age of 25 and over the years his salary has increased dramatically. However, he made no changes to his investment portfolio. Today, at age 37, he still hasn’t accumulated enough money to meet his goal of buying a home. He is very confused. As he has been investing for 13 years, he believes he can achieve this goal. He didn’t know where he had gone wrong.
Manish, on the other hand, has always maintained a balanced portfolio. It invests 50% of the portfolio money in equity instruments and 50% in debt instruments. This way, he thinks that if the stock markets were to crash, only 50% of his portfolio would be affected. Manish is very satisfied with the performance of his portfolio. Over the past year, the stock market has gone up and along with that so has its investment portfolio. However, as everything changes in life, the stock markets also changed direction and began to experience a sharp fall. While Manish was worried, he wasn’t very worried as he believed that only 50% of his wallet would be affected. However, when he reviewed his portfolio, almost 65% of it had taken a hit. Manish was shocked to see such a great loss. He didn’t know where he had gone wrong.
And then there’s Sheena. Her goal was to buy a luxury car in 6 years. Given her risk-return requirements and her time horizon, she invested 20% of her money in an equity mutual fund and 80% in a combination of debt and debt mutual funds. ‘other fixed income instruments. Now, in year five, she took a look at her portfolio and was pleased to see that equity investments had increased significantly and that she was in a good position to buy her dream car the following year. However, when it came time to buy a car, she was in shock. During the previous year, the equity market had fallen sharply, resulting in a significant drop in the value of the equity portion of the portfolio. Although she started saving and investing for this goal 6 years ago, she still has not been able to achieve it. She didn’t know where she had gone wrong.
Where did they go wrong? All three – Ravi, Manish and Sheena – forgot to periodically review and rebalance their portfolios.
Importance of periodic portfolio review and rebalancing
Asset allocation is one of the most important ways to build a strong investment portfolio that can help you reach your financial goals. This involves investing in a combination of investment instruments in stocks, debt, commodities, etc. The idea behind asset allocation is that different investments react differently to a similar set of developments and new flows. Therefore, when one investment is at risk of falling or performing poorly, another investment in your portfolio may do well. In this way, the risk of your portfolio is spread among several investments, thus protecting the fall of the portfolio and potentially improving the returns of the portfolio. From now on, asset allocation is made taking into account three main factors. These include:
- Your return conditions
- Your risk profile
- Your investment period
Based on the above, you can decide how much to invest in stocks, how much in debt, and how much in other instruments. However, it is important to understand that your return requirements, your risk profile and your investment period do not remain constant. They can continue to change. In addition, the investment climate may also continue to change. So, to ensure that you stay on track to meet your goals and that your investment portfolio reflects your risk profile, it is important for you to periodically review and rebalance, if necessary, your portfolio.
Portfolio review and rebalancing involves looking at the makeup of your current portfolio, then assessing whether the investments in your portfolio match your risk profile and are capable of helping you meet your financial needs, in the period of time you desire. If not, it’s time to rebalance and change your portfolio to reflect your changing circumstances and demands.
When should you rebalance your investment portfolio?
There are three scenarios in which you should consider rebalancing
- Modification of the risk profile: When Ravi started his investment journey, he was young, had a small income and also had liabilities. As a result, he had a conservative risk profile, that is, he couldn’t take a very high risk. Thus, its portfolio was mainly composed of debt instruments. However, after paying off his student loan and seeing his salary increase, his risk profile became moderate and possibly even aggressive. Thus, he could easily take more risk by increasing his exposure to equities. He was young, had a good income and had no liabilities. His portfolio should have contained more than 30% equities. What Ravi should have done was review his portfolio and rebalance it by buying more investments in stocks, preferably stocks or hybrid mutual funds and reducing his exposure to debt instruments. If he had rebalanced his portfolio, the share of equities could have increased and helped him achieve his goal of buying a home.
- Significant change compared to the asset allocation strategy: Often when the stock markets recover, the overall weight of stocks in your portfolio can increase and exceed the exposure assigned by your asset allocation strategy. When Manish started he had 50% invested in equity and 50% in debt. So if he invested Rs 100, then Rs 50 was in equity and Rs 50 was in debt. Now when the markets started to recover, the value of the Rs 50 invested in stocks rose to Rs 90. With this increase, the total value of his portfolio became Rs 140 and the exposure to equities became around 65%. Thus, when the markets fell, nearly 65% of its portfolio was impacted. What Manish should ideally have done is review his investment portfolio when the markets started to rise. On examination, he would have noticed that the proportion of shares is growing. This is where he should have chosen to consult an advisor and rebalance by selling some equity investments and reducing the proportion of equities in the portfolio to 50%. Thus, by rebalancing, he could have made sure to continue to follow his asset allocation strategy which would have helped him to reduce the impact of a decline in equities. In a normal market scenario, you should consider reviewing your investment portfolio every year. On the other hand, if there are sharp movements in the market, then you can review your portfolio twice a year. A 5-7% drift of your desired asset allocation may not require rebalancing. However, if you stray more than 10% from your asset allocation strategy, you should consider rebalancing.
- Getting closer to the goal: Most of us create an investment portfolio to achieve our financial goals. In Sheena’s case, she created a strong portfolio and was able to accumulate enough money to accomplish one of her goals. However, when the time came to exit his investments, the equity investments had lost value. What Sheena should have done is revisit her portfolio when she was one year away from reaching her goal. At this point, she should have rebalanced her portfolio by buying back her equity investments and shifting that money to safer debt investments. This would have ensured that any gains made on her equity investments would be protected so that when she finally hit year 6, she would have the money to buy her dream car. Again, rebalancing would have helped her secure the gains she made.
Life is not static. Likewise, your financial plan and asset allocation strategy shouldn’t be static either. If you really want to achieve your financial goals, you need to make sure you invest in line with your asset allocation strategy, periodically review your investment portfolio and make sure you rebalance it if your circumstances change. your risk profile, your return requirements or the market.
As Darwin said,
“It is not the strongest of the surviving species, nor the smartest, but the most responsive to change.” Be responsive and rebalance to survive.
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