Most amateurs believe that investing is all about building a portfolio and continuing with it as it is till their retirement. This, however, is not true - as an investor, you will have to frequently review your portfolio and do timely tune-ups. One of the biggest tasks that you would have to do when you set foot into the world of investment is to rebalance your portfolio from time to time.
It is crucial to understand how and when to rebalance your portfolio, as this can help in regulating the risk involved in some asset classes or funds. In this article, we will take these questions and find out more about rebalancing our investment portfolios.
Understanding What is Portfolio Rebalancing
Before we get into how and when to rebalance the portfolio, let’s first understand what exactly this process is. Rebalancing of a portfolio is simply a procedure where you change the proportion of assets in your portfolio as per your financial goals and risk tolerance. To rebalance your portfolio, you would need to purchase or sell certain securities to achieve the required composition.
As the value of these assets changes, the original portfolio changes correspondingly. This, in turn, changes your risk profile as well. Here is an example to make the rebalancing process more comprehensible -
Let’s assume that Rashid has a long-term investment portfolio that he has targeted towards his retirement.
His portfolio has the following composition -
- 80% stocks - subdivided into large-cap equity and small-cap or mid-cap equities
- 20% bonds - subdivided into National Bonds and corporate bonds
However, over time the portfolio drifted away and he ended up having a composition as follows -
Thus, he ended up selling 5% of the stocks in his portfolio and redirected the funds into purchasing bonds to balance the portfolio as per the original plan.
Reasons to Rebalance Your Investment Portfolio
You should rebalance your investment portfolio for two main reasons -
- Achieving a Higher Return on Investment (ROI)
- Controlling the Associated Risk
Financial portfolios are usually created to achieve two main objectives - good returns and minimal risk. If you do not rebalance your portfolio from time to time, it can drift away from the original composition. While it can increase the ROI, the associated risk may also increase.
Rebalancing not only helps in risk management but also ensures that your portfolio is not dependent on the success or failure of a specific investment security, fund type, or asset class over time.
How Frequently Should You Rebalance Your Investment Portfolio?
The frequency of rebalancing your portfolio depends on the following factors -
- Your cash flow
- Personal preferences
- Type of account from which you are selling the assets or purchasing them
- Transaction costs
- Investment horizon
Two approaches are mainly used to find out how often you should rebalance your portfolio -
- Based on Time - You can rebalance your investment portfolio quarterly, half-yearly, or annually. This approach eliminates psychological factors which can lead you to change your portfolio at the time of market fluctuations.
- Based on Risk Tolerance - Using the risk tolerance approach to rebalance your portfolio has multiple benefits -
- It is an objective approach and removes emotion-based decisions.
- It rebalances the portfolio based on the real-time performance of the said asset class.
- As per a study by Gobind Daryanani, if you use a 20% risk tolerance approach, you can improve the return on investment as per the benchmark that you created initially.
How to Rebalance Your Investment Portfolio?
Listed below are the steps for rebalancing your investment portfolio for better returns and risk management -
- Record - Once you design your asset allocation plan and purchase the required securities in every asset class, maintain a record of the overall cost of each security as well as the entire portfolio. These figures will help you map the progress of each security when you compare them in the future.
- Compare - Review the current value of your investment portfolio and each asset class. For this, you can compute the weightage of each fund in your portfolio by dividing the present value of the fund by the overall present value of the portfolio. The current value that you get will then be compared to the historical figures that you computed at the time of planning the portfolio. With this, you can easily look for any major changes in the portfolio. In case there are no major changes, you won’t need to liquidate the portfolio in the short term.
- Adjust - If you find that the current composition has drifted from the original plan and has increased the associated risk, you can multiply the present value of the portfolio with each percentage weighting that was originally assigned to each asset class.
Keep in mind that the derived numbers would refer to the amount that has to be invested in each asset class to get the portfolio back to its original composition. For this, you may be required to sell some securities (whose weightage is higher than required) and purchase extra securities in the asset classes that have seen a decline in weighting.
Tips to Keep in Mind When Rebalancing Your Investment Portfolio
Here are some tips to consider when rebalancing your investment portfolio -
- Focus on your long-term financial goals - By making short-term changes in your investment portfolio amidst volatile markets, your potential for achieving your long-term goals can be significantly impacted. So whenever you go for the rebalancing, you should keep your long-term goals in mind.
- Do not rebalance frequently - If you rebalance your portfolio too often, it can lower the returns on investment.
- Rebalance your portfolio with cash flows - Channelise the cash flow like the dividend and the interest earned into the underweighted asset classes. When withdrawing the cash, start with your overweight asset classes.
- Keep the costs in mind - To reduce the transaction costs, you should moderately rebalance your portfolio to the original asset allocation composition. For this, focus more on asset classes with overweight or underweight securities in terms of transaction costs to rebalance the investment portfolio.
- Do not deviate from the main objective of rebalancing - The primary objective of rebalancing your portfolio is to minimise the risk involved. While most investors dream of buying low and selling the securities at high prices, it does not necessarily maximise the returns.