Rebalancing the Portfolio

I am new to mutual funds and willing to invest. In many of your responses to questions asked on this forum, you advise “rebalancing of your portfolio once a year”. What exactly do you mean by that?
- Suhas

An ideal investment plan starts with an asset allocation. At its most basic form, it is the breakup of your investments into equity and debt, the latter including fixed income and debt funds. This allocation depends on one's investment time frame and risk tolerance.

If you have a time frame of just two to three years, then your equity allocation should be extremely small or even nil. Money which you can set aside for at least five years can find its way to equity. But even when investing for the long term, an allocation to fixed income is recommended as it provides stability of return to the overall portfolio.

So once you target an equity:debt allocation, you then narrow down on your specific investments within each class. But this does not stay constant. Depending on the performance of each asset class, the allocation automatically shifts. Hence it would need to be rebalanced.

For example - Let's say Mr Dave wanted to invest Rs 1 lakh for the long term. Therefore, he set his equity: debt allocation as 80:20. The equity portion was invested on the lines of the Sensex while the debt allocation was a bank fixed deposit earning 10 per cent per annum (see Scenario-I).

Scenario I Portfolio allocation                        Portfolio allocation     Date    Sensex    Chg in Sensex (%)    Equity (Rs)    Debt (Rs)    Total Invest (Rs)    Equity    Debt 01/02/2006   9390     80000   20000   100000   80   20 01/02/2007   13942   48   118782   22000   140782   84   16 01/02/2008   20465   47   174356   24200   198556   88   12 30/09/2008   12860   -37   109565   26620   136185   80   20 10/11/2008   10536   -18   89764   29282   119046   75   25

Dave invested Rs 80,000 in equity and Rs 20,000 in debt on January 2, 2006. Now every time the Sensex surges, so does his equity investment. Therefore, after two years, his allocation changes to 88 per cent in equity and 12 per cent in debt. Naturally, the risk of the portfolio has gone up too.

In this scenario (see Scenario-II), Dave is no longer a passive investor, but an active one. So he would work at maintaining his asset allocation at 80:20. He started with an investment of Rs 1 lakh on January 2, 2006. His allocation meant that Rs 80,000 would go into equity and Rs 20,000 in debt.

A year down the road, he needs to rebalance it to ensure that the allocation stays. To maintain the 80:20 allocation, he sells equity worth Rs 6,126 and adds this amount to the debt allocation. Similarly, on January 2, 2008, he sells equity worth Rs 8,286 and transfers it to the debt side. After a steep fall in the Sensex, the equity allocation has dipped. So this time, he transfers Rs 14,811 from the debt investment into equity.

So while it may be difficult to pull out of equity during a bull run, it will not expose your portfolio to more risk than you can handle. And should the market tank, your downside will be protected.

This article was originally published on December 12, 2008.