Asset
Allocation - Why Portfolio Rebalancing is Essential ?
by JOYDEEP
SEN, Sen & Apte Consulting Services LLP
It has been proven that
portfolio allocation leads to long-term optimum results on investments.
Awareness among investors is gradually increasing on the imperative of
allocation. Another aspect of portfolio management, which is equally important
but not widely followed, is portfolio rebalancing.
A classical argument of
the investing community against the fund management community is that hardly
anybody gives the exit call at market peak and the argument from fund managers
is that it is difficult to call the peak as the market is by definition
uncertain. The other side of the coin is, hardly any investor buys at market
bottom, though fund managers give the ‘buy’ call.
A partial solution to
the issue is portfolio rebalancing when the market seems to be peaking or
bottoming. This is not about calling the exact top or bottom, but following a
discipline when the market is running ahead. Let us take an example; our
investor in this example follows an allocation ratio of 60:40 i.e. 60% in
equity and 40% in fixed income.
When the market crashed in March 2009 with
Sensex touching 8160 after forming a peak of 20376 in December 2007, his equity
allocation must have been significantly lesser than 60% due to erosion in
market value, depending on time of entry. If he did a portfolio rebalancing by
purchasing equity stocks, he would have purchased cheap.
This is not about
calling the bottom of the market; even if it was done when the market was on
the way down towards 8160, he would have benefitted.
Similarly, when the
market peaked in January 2011 with Sensex at 20,561, it was time to rebalance
the portfolio by booking profits in equity. If he did it sometime towards end
of 2010, it would have been good for him.
Now let’s come to the
present day context. Let’s say the investor with a 60:40 equity: debt
allocation, constructed his portfolio sometime in August 2013 when the Sensex
was at approximately 18,000.
Given the current Sensex
level of around 30,000, his allocation of 60 to equity has now become 30000 /
18000 X 60 = 100.
Assuming a return of
8.5% in fixed income, his allocation of 40 to debt has now become approximately
54. On the total portfolio value of 100 + 54 = 154, the allocation to equity
has now become `100/154 = just under 65%.
Hence on an intended
allocation of 60:40, the current allocation is not very skewed. However, there
is a case for periodic review, to revisit the risk appetite and horizon of the
investor.
If the equity component
is a dedicated long-term investment, then it may be left as it is, unless the
market runs up significantly in the near to medium term.
Otherwise, depending on
the risk appetite and horizon of the investor, if the market runs up fast in
the near to medium term, partial profit booking and rebalancing in favour of
40% in debt may be considered.
Rebalancing faces a
psychological hurdle:
shifting from a high return avenue (this is giving me 15%
return!) to a low return avenue (expectation from debt is only 7.5%!).
On the other side, when
the market is bottoming, one tends to hold on (it will become even cheaper
after a few days, I will buy then). This is where you have to separate your
emotions from your financial investments.
The other question in
rebalancing is, identifying the next best avenue. There is an expectation that
it should have a similar return. To be noted, the next avenue should have a
negative correlation with the existing one, i.e., expected to move in opposite
direction in similar market conditions. That is where you are diversifying your
portfolio.
In the current context,
if you are booking profits in equity and coming to fixed income, do not take
the risk of a long bond fund as the interest rate cycle is likely to be stable
for the time being, with the rate cut cycle having come to an end.
About the author
The writer JOYDEEP SEN is managing
partner, Sen & Apte Consulting Services LLP.
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