A portfolio holds assets that earn different rates of return. Over time, the percentage of assets change, skewing allocation and risk, which triggers the need to rebalance
Building a portfolio to meet your goals is just half the job done. You also have to monitor and adjust it to keep it aligned to your needs. This is because a portfolio typically holds assets that earn different rates of return. Over time the relative percentage of the assets will change, skewing the portfolio in favour of the asset class that earns a higher return. The altered portfolio may then have a different level of risk. Rebalancing helps restore the original allocation.
Monitoring and rebalancing your portfolio is a continuous maintenance plan. You may need to adjust your current asset allocation as the terms to your goals change, or if your needs and goals themselves have become different, or if your ability to take risk is not the same anymore.
Work out the strategy
Just as you have a plan to invest, you need a strategy to rebalance your portfolio too. There are two aspects to the strategy—when and how.
You need to decide when and how often the portfolio will be rebalanced. One way to do this is to set a time-based schedule to rebalance the portfolio. You decide the time interval to the next rebalancing. This could be any frequency: annual, semi-annual, quarterly or even more frequent. While there is no best frequency to select, letting your portfolio drift for longer than a year may mean it is drifting away further from where it should be. If the rebalancing schedule is too frequent, it will imply costs, taxes and time. Rebalancing to a time schedule is usually simple to implement, helps keep knee-jerk reactions to market movements under control and prompts you to action when the scheduled date comes around.
Another method is to define a percentage change in allocation that will trigger the rebalancing. When the allocation to any of the asset classes changes by the percentage defined, then a reallocation takes place. In steady markets, the need for reallocation may be less, while in volatile markets the triggers may be more frequent. Set the tolerance range based on your ability to take risks. You should consider setting different thresholds for different asset classes or sub-asset classes based on the extent of volatility that each exhibits, and your own comfort in the asset class.
A third option would be a combination of the two strategies. For example, you could go for an annual review but effect a rebalancing only if the allocation has altered beyond a defined percentage. This combines the benefits of both the strategies. Since there is a time schedule for rebalancing, the chances of overlooking or procrastinating is reduced. At the same time, you don’t incur costs of selling and re-investing unless there is a significant shift from the original risk features.
Having a threshold that drives action ensures that emotions don’t affect decision making. In a rising equity market, you may be tempted to ignore risks and hold on to stocks, but triggering a threshold limit will make you think of the consequences and rebalance. Selling when markets rise also has the benefit of booking profits.
Once a rebalancing event has been triggered, the next decision you have to make is how to reallocate. The most intuitive way to do it would be to sell the asset class that has breached the upper tolerance level and use the funds to buy into the asset class that has lagged. The advantage of this method is that it is simple to execute, the reallocation is quick and you have the benefit of booking profits in a rising market and investing into another asset class when prices are low. The disadvantage could be the tax implication while selling assets and the costs incurred at the time of selling and buying. Be mindful of the taxability aspect while selecting the assets that are to be redeemed to rebalance. Look for benefits such as lower taxes on long-term capital gains, indexation benefits and setting off losses to reduce the impact of tax.
Another strategy would be to realign by investing all future investible funds into the asset class that is lagging so that its proportion goes up. Other cash flows from the portfolio, such as dividends, interest and maturity or redemption amount from investments should also be used to push up the holding in the under-weighted asset class. This way you will avoid taxes, and costs will be restricted to new investments. The drawback is that this method takes time.
Steps to rebalancing
Executing a rebalancing strategy effectively requires a system. The first step is to create a list of all the investments you hold and classify them so that you know your current asset allocation. Compare it with the asset allocation that was determined as the most suitable. Make changes to the allocation so that your portfolio reflects what you need. The preferred asset allocation may change if your goals have changed, thereby altering your risk and return preferences.
Having a rebalancing strategy imposes discipline, and helps you focus on your needs instead of market movements.