Whether you invested your money one year ago following a well-thought-out investment strategy and then not knowing how to fix the current state of your investment portfolio, or whether it's changed dramatically since, you should be asking yourself, “What went wrong?” This situation is frequently referred to as a classic case of portfolio drift. As the various marketplaces change, the combination of assets that you thought would provide you with ‘conservative’ investments could actually morph into a type of investment ‘gamble,’ which is why the rebalance strategy is not something that you can choose to do or not, but rather something that is critical to the continued success of your investment plan.
In this article, we’ll discuss the importance of maintaining your asset allocation, how to protect your investments from taking on excessive risk by regularly reviewing and adjusting, and the methods that you can implement to keep your portfolio on target.
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What is Portfolio Rebalancing?
At its most basic level, portfolio rebalancing is simply a process of bringing your asset allocations back into alignment. Portfolio rebalancing requires rebalancing your portfolio every so often by either selling some of your investments that have appreciated to get back to your original level of asset allocation or buying more of the assets that have depreciated.
Let’s say you initially had an investment strategy of 50% stock and 50% bond.
If the stock market rallies, your portfolio might shift to 70% stocks and 30% bonds.
While a higher balance looks good, your portfolio is now significantly riskier than you planned.
To maintain your 50% stock / 50% bond allocation, you would sell off some of your high-performing stocks and use the proceeds from those stocks to purchase additional bonds, bringing your portfolio back to your desired 50% stock/50% bond allocation. Understanding the fundamentals of the Equity Market Basics is critical when it comes to making informed decisions about which assets to purchase.
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3 Key Reasons Rebalancing Portfolio Matters
Some investors do not want to take the time or thought required for rebalancing their portfolios, as they think they are selling the "good" (or better-performing) asset class(s) in order to add more of the "bad" (or under-performing) asset class(s). While this may be one of the reasons for not wanting to rebalance, it is also essential for ensuring that your portfolio continues to meet your long-term financial goals. Here are several important reasons you should not neglect this process.
1. Risk Control and Management
Rebalancing helps control and manage risk in an investment portfolio. Higher-risk asset classes tend to grow at a faster pace than lower-risk asset classes. Therefore, as portfolios are left alone to grow, they generally drift toward higher levels of risk. If the stock market crashes while a portfolio is "overweighted" on stocks, the investor's losses would be severe, much more than anticipated.
2. Enforcing "Buy Low, Sell High"
Rebalancing helps enforce the principle of buying "low" and selling "high." Even though buy low, sell high is common knowledge, emotions are a major factor driving the opposite behavior. The automated nature of rebalancing requires investors to follow through with the "buy low, sell high" principle.
3. Maintaining Financial Discipline
Generally, portfolios are developed with certain goals in mind. When a portfolio is not rebalanced regularly, it isn't following the original investment strategy or plan, and therefore is truly open to market volatility. Periodic rebalancing provides for the continuing alignment of an investor's strategy with that investor's time frame for investment success.
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Common Rebalancing Strategies
There is no single best way to rebalance a portfolio.
If you are monitoring your threshold manually, it may take some time and be difficult to accomplish. Therefore, consider looking into some of the Best Portfolio Management Tools for Indian Investors that will help automate the process and allow you to keep track of it.
Also, keep in mind that when selling an asset to rebalance, a tax event occurs. If you are selling stock for a gain, you will want to be mindful of the taxes incurred on your profit. Before executing a large-scale rebalancing, it would be a good idea to read a guide on How to Calculate Capital Gains Tax in India so that you do not have an unwelcome surprise in the form of a tax bill.
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Conclusion
Rebalancing an investment portfolio is similar to a regular checkup on your financial health. It does not mean to chase the highest return every year; rather, it means to make sure you have enough assets during times of market volatility in order to be positioned for long-term success.
Whether you follow the calendar-based method of rebalancing or the threshold method, the important factor is to remain consistent in your rebalancing strategy. By remaining consistent with your plan, you will reduce your chances of emotional investing, manage your risk, and remain focused on your long-term goals.
Your Next Step: Log in to your account now. Has your portfolio allocation drifted in excess of 5% from your desired target? If so, you may want to consider rebalancing.
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