The Importance of Rebalancing Your Investment Portfolio | Spring Money

Investing can be a great way to grow your wealth, but the risk will always be a part of this journey. Market volatility, economic uncertainty, and other unpredictable events can cause your portfolio to become unbalanced leaving you vulnerable to losses. That's why rebalancing your portfolio is essential for your long-term investment success.

What is Rebalancing?

We normally set up an asset allocation strategy that depends on our goals and present finances, but after time the weightage of each asset in our portfolio will change. Thinking why did this happen? Because the market value of each asset in our portfolio performs differently, some might show 100% profit, while the rest had 20% or say 50% loss. The goal of rebalancing is to bring our portfolio back to our target asset allocation if it has strayed from our goal due to changes in market values.

Let’s understand this with an example. Harshad worked hard and saved ₹10 lakhs by the age of 30, in the year 2016. Now he wants to invest this amount for his retirement which he is planning at the age of 55. For this, Harshad started his hunt for the best financial advisory services at a reasonable price, and finally came across Spring Money, a non-commission-based and trusted advisory partner.

After having a discussion with a financial advisor, Harshad came across an asset allocation strategy following which he invested 50% in equities(small-cap), 40% in Government securities(G-sec), and 10% in gold.

The above chart which depends on the actual performance of assets between the years 2016 and 2017 shows that Harshad’s investments in equity grew from ₹5 lakhs to ₹8 lakhs, while the other two assets underperformed comparatively, with the following returns; Investment of ₹4 lakhs in G-sec, became ₹4.89 lakhs, and investment of ₹1 lakh in gold became 1.27 lakhs.

The good news is that in the year 2017, Harshad’s portfolio has shown a return of over 40%. But you can see that the weightage of assets across the portfolio got changed due to changes in market values. Doing adjustments to bring your portfolio back to the target asset allocation strategy is what rebalancing is. Further, we will see why it’s of extreme importance to stick with the decided allocation strategy to successfully accomplish long-term goals.

Why Rebalancing is Important?

Rebalancing is important for several reasons. First, it helps you maintain the risk and return characteristics of your portfolio. If one asset class outperforms the others, it may become overweight in your portfolio, increasing your risk. By rebalancing, you sell some of the overperforming assets and buy more of the underperforming asset, bringing your portfolio back to your target allocation plan.

Let’s imagine that Harshad got overconfident about his investments in equities because it alone gave a return of 60% in a year, and planned to drop the rebalancing strategy for his portfolio. And suppose following where the performance of three asset classes during the next year; Equity fell down by 24%, while G-sec and gold both gave a return of 8.5%. Now see how his portfolio will perform in the above-mentioned situation, where rebalancing is ignored.

Harshad's investment of ₹10 lakhs in the year 2016, grew to approximately ₹14 lakhs in 2017 and in the year 2018 closing decreased to approximately ₹12.77 lakhs. Now let’s find out the outcome if Harshad would have rebalanced his portfolio and brought back the weights of each asset to the target one, as decided initially.

In the above chart, you can see that now he has done rebalancing, his total portfolio amount is around ₹30 thousand more than the situation in which he ignored rebalancing his portfolio. After Harshad's investment of ₹10 lakhs grew to ₹14.16 lakhs in 2017, he worked on distributing weights of this total amount among all three assets as planned initially.

Also, ignoring rebalancing for once initially has resulted in a heavy loss, of 3% of his investment. Imagine what might be the total losses if Harshad in the time span of 25 years ignores rebalancing plenty of times.

Consequences of Not Rebalancing Portfolio:

If you don’t rebalance your portfolio, it can become unbalanced over time. We saw this in the above example, where Harshad initially planned to allocate 50% in equities, 40% in bonds, and 10% in gold, by the end of the first year his portfolio became 56.5% equities, 35.5% G-sec, and 8% gold. Leaving his portfolio imbalanced made his investments more vulnerable to risks associated with the equity market because now a major part of his investment will be relying on one asset class. Rebalancing can reduce such risks and ensure that your portfolio is aligned with your long-term investment goals.

When to Rebalance your Portfolio?

There are no rules on how often or when to rebalance an investment portfolio. This could depend on various factors like investment duration, income, expected returns, risk-taking capability, and much more. However, most big-sized investment companies prefer rebalancing their investments quarterly, but for individuals like us once a year is also fine.

Apart from this rebalancing can also be done if the investor after time decides to change his target allocation strategy. For example, Harshad’s initial allocation across the portfolio was, 50% equity, 40% G-sec, and 10% gold, but after 10 years, he considering advice from an advisor decided to place a new target allocation which can be 40% equity, 40% G-sec, and 20% gold or something different. The above reason for rebalancing could be a result of many factors linked to Harshad’s personal finances, or a slight change in his goals.

How to do Rebalancing?

Rebalancing is a simple process, but it does require some attention to detail. First, you need to determine your target asset allocation. Once you have your target allocation, you can compare it to your current portfolio and identify any imbalances.

To rebalance, you will need to sell some of the overperforming assets and buy more of the underperforming asset. Like in Harshad’s case his investments in equities overperformed the other two so to do rebalancing he has to sell some portion of equities and reinvest that amount to buy more quantities of the other two assets.

Conclusion:

Rebalancing your portfolio is an essential part of long-term investing. By maintaining your target asset allocation, you can reduce your risk and ensure your portfolio aligns with your investment goals.