Rebalancing portfolios will help investors fight market vagaries

Creating a good investment portfolio is an art and a science. However, just “set it and forget it” is not enough to achieve the long-term investment goal. The portfolio gets out of balance over time, and the asset and sub-asset class weights fluctuate and change due to market movement. The result is that allocations deviate from the ideal asset mix, changing the portfolio’s risk-return profile. Rebalancing is the act of bringing the portfolio back to its desired asset mix aligned to the investor’s risk-return profile.

Based on the returns of the investments, the weightage of each asset class should change, altering the portfolio’s risk profile. Rebalancing helps to keep risk within one’s desired limit. It ensures that the portfolio isn’t singularly dependent on the success or failure of a particular investment, asset class, or fund type. It helps one avoid relying too much on emotions when making important investment decisions and brings discipline. It allows aligning the investment with the goals by periodically rebalancing the portfolio. Rebalancing keeps portfolio drifts under check. Such drifts may not be evident because they can happen gradually. If one is not paying regular attention, they can skew the asset mix and expose to more risk.

An important question is when and how to rebalance? It is required when there is a significant shift in the asset mix vis a vis original and/or there is a change in an investor’s risk profile and/or when an investor is closer to the goal. There are several methods to rebalance. An investor can either define a frequency with which they will continually assess the portfolio allocation’s current status or set asset allocation ranges. In periodic (time-based) rebalancing, investors set a schedule, and rebalance the portfolio according to that time frame. For example, every 12 months, measure the actual investment mix against the target. Based on the variation, decide whether to make modifications or wait another year to rebalance. In tolerance-band (percentage-based) rebalancing, investors establish specific thresholds that — if crossed — trigger rebalancing.

This approach means the investor must monitor allocations more frequently than periodic rebalancing, which may only require one to check the portfolio annually. One can also consider a combination strategy, using both periodic and annual rebalancing with tolerance bands.

By selling high-performing investments and buying lower-performing ones, rebalancing can be achieved. It can also be done strategically by using other purchases and sales to rebalance. Often investors make regular portfolio contributions or withdrawals that can help them rebalance at a reduced cost. One should be cognizant of the cost involved while rebalancing. The impact of capital gain, exit loads and brokerage costs have an impact on the cost of rebalancing.

We plan, design and execute. But things may not go as per our plan. This is where rebalancing comes in. Portfolio construction gets high importance but rebalancing does not. Rebalancing ensures that the portfolio and the strategy remain relevant and help the portfolio survive through the tides of different market cycles and help attain the long-term investment goal.

(The writer is Co-founder & Partner, Fintrust Advisors LLP)