How to rebalance your portfolio

In February, we had provided some do-it-yourself guidelines on maintaining a long-term portfolio. Many of you appreciated it and said you found it useful. Please read it if you haven’t.

One of the points in that playbook was about portfolio rebalancing.

Since many of you continue to have doubts on what is rebalancing and how to rebalance a portfolio, we thought we’ll do a separate one here in detail. This exercise will help you achieve 2 objectives:

• One, you will ensure that you stick to your asset allocation and thereby keep your portfolio risk even
• Second, you will periodically be booking profits in an inflated asset (overvalued asset class) and redeploying in a deflated one (undervalued one). Indirectly, you will be selling high and buying low, without having to watch the market level every time.

The discussion is most relatable to mutual fund portfolios. But you can apply the principles to any combination of products – as long as the focus is on asset allocation.

What is rebalancing

Many of you may be using the term rebalancing interchangeably with reviewing. While that is not entirely wrong, we’d like to establish some clear definitions of what we mean:

Rebalancing: Rebalancing is essentially re-aligning the asset allocation weights in your portfolio to bring them back to your original level or the desired level you fixed. For example, if you started out with a 60:40 portfolio of equity and debt and it becomes 70:30, then selling equity and redeploying in debt to bring it back to 60:40 is called rebalancing.  

Reviewing/Changing funds is not rebalancing – Many of you use the term ‘rebalancing’ to denote review of your funds. That is, you want to know whether to sell a fund that is not performing and invest in a better fund. We call that ‘review’. However, while rebalancing, you can definitely weed out bad performers as part of the rebalancing process.

Reallocation: When you decide to change or shuffle your asset allocation to make it riskier or to reduce the risk in your portfolio, we call it reallocation. For example, let’s assume you had a 70:30 portfolio. By the time you are, say, 56, you want to slowly reduce the equity component and move to income earning options or lower risk debt options. In this case, you are re-allocating your portfolio – i.e. shifting from equity to debt, either gradually or in one shot. This is a separate topic to write about – in the context of retirement planning, de-risking or income generation –  and is not part of this discussion.

The act of rebalancing

All of you wish to be sounded off when the market is at a peak so that you can book profits. You also wish to know when to invest more, when the market falls. Since this is not an easy task, rebalancing is often a good proxy to fulfil this wish. But that is not the primary job of rebalancing.

When to use

Rebalancing seeks to reduce massive swings (falls) in your portfolio and as a side-effect will also curtail some amount of growth in a prolonged rallying market. This is something you need to be aware of.

Therefore, it is our view that rebalancing has a larger role to play in portfolios with goals less than 10 years. This is because over a longer period, there is a higher chance that your portfolio reacts less to market swings. Over shorter time frames there isn’t much time to recover from deep shocks.

Of course, you might want to practice rebalancing as a hygiene, irrespective of what time frame you have, but know the limitation that we mentioned in terms of curtailing some growth. Our illustration further down will make that clear.

Now, let us get into the act of rebalancing:

1. Checking your portfolio on whether it needs rebalancing can be an annual affair. Take calendar beginning or end or even a fiscal year end but stick to it consistently every year.
2. A minimal deviation in each asset class does not call for rebalancing. It will lead to unnecessary tax impacts and exit loads.
3. Keep a thumb rule of over 5 percentage points deviation in any of the asset class to trigger a rebalancing on your side. There is nothing very scientific about this. Starting this level of deviation, your portfolio would actually begin to seem inflated in an asset class (say equity) and therefore hint that it is overvalued.
4. If your portfolio has not crossed this threshold but is at the verge of crossing, you can still do a rebalancing if you see that market is rallying sharply (like 2007 end in our illustration later).
5. Once you identify that your portfolio needs rebalancing, review your funds next. You can use our MF Review tool for this and exit the underperformers – depending on whether your portfolio requires equity or debt to be reduced. Funds that are a sell on our tool can be used to exit or reduce. If there are no sells, the holds can be used to prune.
6. If your equity has risen and you have no underperforming funds, based on our MF Review tool, see which category has inflated more (midcap or small cap or large cap) and accordingly reduce.
7. If your equity has fallen, like it has in the illustration below (in 2008), then bring back your category allocation in large caps/multi-caps and midcaps to where it was before. If the market correction spooks you, add only index funds multi-caps. This will ensure you don’t have to take any call on whether midcaps will come back sooner or languish.
8. When debt is inflated, you might often find that it is either from high duration funds (gilt, dynamic bond) or risky funds. Prune those (of course after first applying the rule for underperforming funds).
9. When you need to add to debt (reducing equity), do not try to take duration or credit calls. Use a combination of high-quality medium duration funds, short duration funds and even liquid funds in your portfolio. It is better to spread across time duration. That way, you will remain neutral to interest rate risks.
10. Also, booking some profits and keeping it in liquid funds will come in handy to redeploy when the next correction in equity happens. Please note that we cannot put a number to this as much depends on whether you already hold liquid funds or not. In general 5-10% of liquid funds or overnight funds (outside of emergency needs) in your long-term portfolio is good to have, when you book profits in equity.
11. An important point when you are increasing exposure to an existing fund: make sure the exposure of that individual fund, in the case of equity, is not in excess of 20-25% of your portfolio in the case of debt, not over 10%-20% . Introduce a new fund, if you have an already concentrated portfolio. Please note that this is subject to individual limits you might have for midcaps or say high-risk debt funds (not over 10%) and so on.

The illustration below gives a simple example of how rebalancing helped. This is based on lumpsum investments. With SIPs. rebalancing may be a further rare occurence, since, you are averaging already.

Please note that this does not also consider taxes. It simply tries to illustrate how your wealth may grow slower in years like 2007, because you rebalanced. But it also tells you how you would have tackled the fall much better in 2008 and also because of averaging, your returns when the uptick happened in 2009 would still look better.

Selling funds

Many of you ask us whether the tax impact will not be very high when you do rebalancing. What you need to keep in mind is that the threshold of 5 percentage points (over original level) we have given will very rarely occur in a space of 1 year. It is only in years such as 2007 that you will see a rebalancing called for within a short span. So, you will most likely be holding funds which have fully or partly (if SIP is running) crossed both exit load and STCG periods. You will not have much to worry on this count.

If you have additional money to invest, instead of adjusting within your portfolio, deploy afresh in the undervalued asset class instead of selling in the over-valued asset. This will assuage your concerns on tax implication. But note the following:

• If you are investing fresh sums (and not rebalancing with existing money), we would prefer fresh investment for equity alone(where equity has fallen).
• When equity falls, you know you are value averaging. However, in most cases when debt falls, it is because equity is inflated and not because debt is significantly undervalued.
• There will be rare instances of debt undervaluation due to fall in your gilt funds or dynamic bond funds (high rate scenario). But these are hard for you to identify. Your debt might even have fallen because of some high-risk funds seeing sharp NAV falls. Hence, it can be risky to think debt is undervalued and pump in more fresh money. This is why we earlier suggested that you stick to safe funds, without duration or credit calls when you re-deploy in debt.

Please note that there will be many other smaller issues you will face when you try to do rebalancing. I have seen very meticulously drawn spreadsheets by financial planners on this and also seen individual investors finding it too complex and giving it up.  

But it is my personal belief that it is not necessary to be very accurate nor be correct to the last level of detail.

All you need to ask yourself is this: “has my equity or debt or gold swelled beyond a limit that I set myself initially. If so, let me put it back in order”.

The rest of the benefits will follow. If you struggle because you hold an unwieldy portfolio – well, that needs a separate playbook 😊

Disclaimer: we are not financial planners nor portfolio advisors and do not do review or rebalancing. This is an educative series to help you deal with your portfolio.