Why and how to rebalance a portfolio

Investment advice these days is highly focused on asset allocation. Financial planning is the buzzword and investors routinely receive advice on how they should allocate their savings to various asset classes, such as equity, debt, real estate and gold. If equity has delivered poor returns in the past five years, is investing fresh money in debt good enough? What should be revised? When and how? Rebalancing refers to modifications in the portfolio based on a review.

Rebalancing has received a bad name due to the obnoxious practice of churning, which refers to the frequent changes in a portfolio by advisers, who replace one product with another, more to enhance their own commissions, than to benefit the investor. Investors tend to suffer losses, and pay high costs and taxes when their portfolios are churned. Awareness about this hurtful practice has increased and investors are wary when advisers ask them to make modifications in their holdings. Rebalancing is skirted by several financial planners, who want to build a reputation of working in investors' interest. Investors need to differentiate useful and necessary rebalancing from harmful churning.

There are two primary objectives of rebalancing a portfolio. First, it should help the portfolio to be realigned to the changing needs of the investor. Second, the risk of the portfolio should be managed actively. Rebalancing may not result in higher returns, but research has shown that a well laid out rebalancing strategy can reduce risks significantly. Rebalancing ensures that the overall composition of the portfolio is realigned to investor needs and preferences.

Consider a young couple with bank deposits, fixed maturity plans and tax-saving equity funds in their portfolio. They decide to buy a house on loan, which reduces their ability to save, but enhances their sense of wealth and well-being. A rebalancing strategy needs to be worked out. They should desist from liquidating their other assets and concentrating their wealth in the single property. The target asset allocation of earning couples should include liquid and flexible assets; therefore, their investments after they buy an illiquid asset, such as a house, should be directed to achieve that end.

Consider another example. It is not uncommon for retired people to think only of investments that yield a fixed income once they retire. They see these as low-risk options. Several retiring investors have also bought homes earlier in their working lives and choose to live in it after retirement . However, a retirement portfolio with, say, 50% of the wealth in fixed income assets and 50% in a selfoccupied house, may require rebalancing. It may be poorly aligned to the most important needs of retirement , namely inflation-indexed income and flexibility to draw down for emergencies. A post-retirement span of 20-30 years is not uncommon today. So, they could consider rebalancing their investment in one property into two smaller units, one of which can earn an inflation-adjusted rental income. They can also allocate a small portion of investment to equity to enable growth and help fight inflation in later years. In the first 10-15 years of retirement, they may indulge in alternate professions, earning some income anyway. So the overemphasis on safety and income in early years of retirement may be poorly aligned to their needs in later years.

Rebalancing is thus the art and science of ensuring that the portfolio is aligned with the investor's changing needs. The second type of rebalancing , which is based on the performance of assets held in the portfolio, is tougher to implement. This is a specialised, tactical asset allocation skill, not common among financial advisers and wealth managers. Several advisory firms and wealth management arms of banks and broking houses run model portfolios, which reflect their views on equity, debt, gold and such assets and recommend changes to holdings. These are not implemented through an automated process, but are left to the ability of relationship managers to convince the investors to make the change.

Another approach is mechanical rebalancing to a predetermined formula , at specific time periods. SIPs and STPs are variations of this theme. There are also asset allocation products that apply quantitative models to move money between equity and debt. However, these haven't caught the fancy of investors, who do not see risk reduction as a required benefit, and instead focus on return maximisation. A mechanical rebalancing formula will pull money out of a high-return asset and deploy it in a low-return asset.

Investing has to be seen as a dynamic exercise that requires review and modification both for a given situation and for the performance of the holding . Not all rebalancing is mindless churning.

—The author is Managing Director, Centre for Investment Education and Learning, and can be reached at uma.shashikant@ ciel.co.in

Source:timesofindia.indiatimes.com