The Indian equity market has provided significant returns from the low of March 23, 2020. Many analysts and investors wonder why there is no correction in the market, and most think that the market is overvalued. However, in the financial year 2021, one could witness the largest drawdown between February and April 2021for around 8.5%. If investors are not comfortable with any future drawdown, then they should rebalance their portfolio. Let us discuss in detail regarding portfolio rebalancing.
Why to rebalance?
The primary rationale for portfolio rebalancing is to establish better risk control and ensure that the portfolio is not overly dependent on the success or failure of a particular investment, asset class, or fund type. For instance, let’s suppose you had invested Rs 10,000 in company A and Rs 10,000 in company B in January 2020. At the end of one year, total investment became Rs 40,000, and along with the dividend, the total return is Rs 41,000. Due to market forces, both the companies may not perform equally. So, while company A gives you Rs 17,000 at the end of one year, company B returns Rs 24,000. When you began your investment, both stocks had the same weight. At the end of one year, one stock dominated your portfolio with 60% weight. If this company performs poorly in the coming year, then your investments would see a downward turn in no time at all. Hence, rebalancing is essential.
When to rebalance?
Investors could rebalance their portfolio based on the time strategy wherein the portfolio is rebalanced quarterly or yearly irrespective of how much the portfolio’s asset allocation varied from its original target. So, determining the frequency with which one should rebalance their portfolio depends on the investor’s risk tolerance, costs associated with rebalancing, etc. This is popularly known as time-based rebalancing.
Under this approach, investors first identify asset classes that deviated from the planned allocation using a tolerance threshold limit. Then, sell investments in those asset classes that exceed the planned allocation to bring them in line. Then use the proceeds from that sale to invest in those asset classes that have fallen below the allocation you want. Let us understand the same with an example.
For instance, your asset allocation plan includes 10% investment in mid cap firms. Twenty per cent of this allocation is 2%. If you use a tolerance threshold, you would rebalance when the mid-cap asset allocation dropped below 8% or above 12%. In either case, the asset class would have drifted from the planned allocation by 20%. If an asset class comprised 50% of a portfolio, you would rebalance …….