Smart investing: Time to rebalance your investment portfolio

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© Provided by The Financial Express Generally, investors choose their portfolio to have some predetermined asset allocation to suit their financial goals with an appropriate level of risk.

After a year of double-digit stock market returns, it may be time to rebalance your portfolio. This will ensure that you are not deviating from your long-term investment plan. It is a good idea to do a detailed analysis of your portfolio at the end of the year or at the beginning of the calendar year. Let us discuss the process in detail.

Why is rebalancing required?

Generally, equities are the most preferred asset class used for capital growth while fixed income is often earmarked with the primary purpose of capital preservation. The strong 2021 equity market performance most likely pushed many investors away from their target portfolio allocations.

The objective of allocation is to balance various risks while working toward long-term objectives by targeting a certain percentage of your portfolio to be invested in various asset classes broadly in equities and fixed income. In a year where equities outperform fixed income, portfolio rebalancing is essential to move some part of the wealth that was created on the equity side of the portfolio to the fixed income side of the portfolio to preserve the newly created wealth.

How does the asset mix change?

Let us consider an example wherein the portfolio consists of 60% in equity while 40% in fixed income. Again within equity you have 35% large-cap, 17% mid-cap, and 8% small-cap. Let us assume that the large-cap, mid-cap and small-cap grew by 43%, 70%, and 103%, respectively in the last one year. Thus your targeted asset allocation would have moved from a 60:40 equity- fixed income mix to 69% in equity (36% large-cap + 21% mid-cap + 12% small-cap) and 31% in debt.

To get back to the targeted asset allocation of 60-40%, you should use the technique of portfolio rebalancing, meaning that you need to sell a part of equities and invest more in fixed income.

Advantages of portfolio rebalancing

Generally, investors choose their portfolio to have some predetermined asset allocation to suit their financial goals with an appropriate level of risk. When markets fluctuate, weightings may drift away from their original preferences. Generally, in the long run equities tend to perform better than bonds. And if no rebalancing is done periodically, there is a higher probability that the portfolio will start to be skewed more towards equities. So, it may expose investors to additional risk during periods of volatility, with the possibility of bigger future losses.

Thus, rebalancing brings back the portfolio to your original asset allocation. It can be done in two stages. In the first stage, determine the total investment into the targeted ratio and then compute what asset class should be bought and sold and by how much.

To conclude, it is essential for an investor to ensure that portfolio allocation remains within his risk tolerance and rebalancing is to be done periodically, at least once a year to make sure that market performance does not pull portfolio allocations too far from their targets.

P Saravanan is a professor of finance & accounting in IIM Tiruchirappalli