Portfolio construction and management is a continuous process. Selecting investment products for our needs and designing a portfolio is the easy part of portfolio management. It is even more important to ensure perfect equilibrium between components in our portfolios. This is where regular portfolio rebalancing comes into the picture. Rebalancing helps maintain an optimal balance between various asset classes in our portfolios. Most of us fully understand the importance of rebalancing our portfolios at regular intervals. But very few of us actually go ahead and do it. And even fewer do it effectively. Therefore, today I am going to prescribe a set of simple guidelines using which we can rebalance our portfolios effectively.
The first and most essential prerequisite for effective rebalancing is absolute clarity on our desired asset allocation. It is our asset allocation that sets benchmarks against which to carry out our rebalancing activities. Those of us who lack clarity on an ideal asset allocation can enlist professional help. In most cases, a long term portfolio can be constructed with an initial allocation of 60% equity and 40% debt. This is because a portfolio with a 60-40 split between equity and debt represents a reasonable balance between asset classes for most individuals. For multiple financial goals which have varying time horizons, a goal based approach may be followed. Each portfolio may have an asset allocation strategy specifically designed to help achieve that particular goal.
Next we need to define our conditions for rebalancing. We must realise that portfolio rebalancing is a tool for risk management. It optimises portfolio returns by protecting the gains achieved by our portfolios in the past. We must look to book gains from asset classes which have done well and park them in asset classes which have decreased in value. Doing this will bring our exposure to the asset classes within our portfolios back in line with our intended asset allocation strategies. Look at the infographic below for a better understanding of the rebalancing process.
It would be a good idea to carry out the rebalancing exercise on a day when we are free from all our other responsibilities for at least a few hours. This allows us to focus all our thoughts and energy on the rebalancing exercise so that we can do a good job of it. We must also look to chalk out a clear strategy regarding how we are going to carry out the rebalancing exercise. We must develop a clear flow of how each activity in the rebalancing exercise will be sequenced. We must also set threshold limits (say 5%) beyond which we would rebalance.
Assume that we begin with an asset allocation of 50-50 between debt and equity, and a 5% threshold limit. When our equity allocation goes to 55, we would need to rebalance from equity to debt. Within our equity portfolio we must redeem from our losing investments. The realised losses can help us set off our future capital gains. We may also have multiple investments within the same category. Paring our exposure within such categories provides another avenue for rebalancing. Redemprions from both these areas may sometimes be insufficient to hit our rebalancing targets. We would then need to redeem from our winning investments until our rebalancing target is achieved.
So to sum up, a clear asset allocation strategy serves as a clear benchmark for effective rebalancing. The choice of threshold limit for rebalancing does not matter as long as we initiate a rebalance every time the limit is hit. Rebalancing improves portfolio returns by locking in past gains and rationalising portfolio risk. We therefore need to have the discipline to move money from asset classes that are doing well to those that are not. Only then would we be able to rebalance effectively. The costs and taxes involved with the rebalancing process may seem undesirable. But they help us avoid the undue risk and consequences of running lopsided portfolios. All of this goes to show that the value added by portfolio rebalancing makes the exercise well worth the effort and energy involved.