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Portfolio Rebalancing - Know the Importance of Portfolio Rebalancing - ABSLMF Blog

Importance of Portfolio re-balancing

Mar 08, 2018
4 mins | Views 191

Before you can attempt to rebalance you must realize that there was something that was on balance. Only then, can you think of rebalancing.

What is balancing?

Let us understand the concept with an example.

Sunita, Suman and Meena are three close friends. They are of the same age and height and they are above average in class and also they have tastes and preferences which are similar. But, the one thing starkly different between the three of them is their weights which now are

  • Sunita weighs 70 Kg
  • Suman weighs 55 Kg
  • Meena weighs 40 Kg

    Note that all of them weighed 3 Kg when they were born around the same time but now weigh as above. When you look at all three of them in a group you will probably say the following

  • Sunita is overweight
  • Suman is normal weight and
  • Meena is underweight

    While the mothers of Sunita and Meenamay rue body condition of their children Suman’s mother may not. By the same token, Sunita and Meena must be wondering what they must do to become like Suman. The obvious answers are that

  • Sunita must go on a diet to reduce weight and
  • Meena must eat well to put on weight.

    Why do Sunita and Meena want to become like Suman? They realize that their respective weight conditions may pose health risks as they progress in life. They feel that normal body weight is good for health and so they envy Suman.

    Something similar is happening in the world of investments. A balanced portfolio is one in which you invest in different asset classes with different risk profiles. The element of risk creeps in because if the returns are high it may also be risky – like investing in stocks. But if you invest in government securities or fixed deposits your returns are low but you carry much lower risk. Of course, you carry no risk if you keep your money in cash but there is no return also.

    A balanced portfolio follows the old adage ‘don’t put all your eggs in one basket.’

    You create a balanced portfolio to spread your investments from high risk to low risk instruments. It means that you invest in stocks (high risk), government bonds (low risk) and cash (no risk). This helps

  • To guard you against unexpected falls in the stock market which may erode your capital
  • To prevent you from investing only in low risk instruments which may limit your possible returns
  • To prevent you from keeping your money only in cash which is safe but fetches no return

    There is another aspect to investments in low risk and high risk instruments. It is possible that

  • When you are young you may want to risk more by investing in stocks
  • When you are older you may want to risk less by investing in bonds
  • At all times you want to keep some cash to help you in case of emergencies

    Thus, you can create your balanced portfolio depending on the risk you want to take.

    Let us take the three ladies in our weight analogy to illustrate the concept of rebalancing. The three ladies have the same amount of money to invest and they invest as follows

  • Sunita invests more in stocks (high risk)
  • Suman invests spreading the risk between stocks and bonds and cash in reserve
  • Meena invests more in bonds (low risk)

    Now, imagine what happens when the stock market does well

  • Sunita gets high returns
  • Suman gets balanced returns
  • Meena gets low returns

    Yet again, imagine what happens when the stock market does badly

  • Sunita gets low returns and possibly erosion of capital
  • Suman gets balanced returns
  • Meena continues to get low returns

    Thus, you can see from the above that a balanced portfolio (Suman) works well under different market conditions.

    Let us assume that all three friends invest the same amount of money in a balanced portfolio with the proviso that each invests with the same proportion between stocks, bonds and cash but with different instruments. For eg. Let the proportion be as follows

  • Stocks 40 percent
  • Bonds 40 percent
  • Cash 20 percent

    After a few months we find that the value of the investments is different for each of our ladies because of the performance of their instruments. Now

  • Sunita’s proportion is 50, 30 and 20
  • Suman’s proportion is 40, 40 and 20
  • Meena’s proportion is 30, 50 and 20

    Now, remember in the weight analogy that Sunita and Meena wanted to be like Suman. Here too, they can be like Suman by following the rebalancing strategy.

    Thus, rebalancing is the process of bringing back the proportion of investment to the original proportion at the beginning of the investment cycle.

  • How do you rebalance? Again, let us get back to the three ladies.

  • Sunita can rebalance by selling some stocks and investing in bonds to keep the original proportion
  • Meena can rebalance by selling some bonds and investing in stocks to keep the original proportion
  • Suman may not need rebalancing as the proportions are intact

    You must note here that if Sunita and Meena have some additional funds they can rebalance by investing the additional funds in the appropriate instruments (Sunita in bonds and Meena in stocks) to retain the original proportions. If Suman too has additional funds she can invest in both instruments in the same proportion. Thus, all three get back to the original proportion by rebalancing their portfolios.

    The rebalancing process can take place if

  • There is a change in the market conditions affecting the proportions
  • Your risk taking ability changes and you want to change the proportions

There is no set date for rebalancing but it is worthwhile to keep checking the proportions periodically so as to see if your original proportions remain intact. It is something like our three ladies checking their weights periodically.

The most important benefit of a rebalancing exercise is to take emotion out of investment decisions. You rebalance whenever your proportion goes off the original proportion mark.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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