If ‘diversification’ is one of the first lessons of investing, then ‘rebalancing’ is surely the second. Spreading assets across asset classes – equity, debt, real estate –is an efficient way to reduce risk. The split between assets depends upon individual goals and risk profile. A conservative investor with a short-term goal is more skewed towards debt and an aggressive investor more towards equity. As the retail market got used to this new concept, more and more people began to split their total portfolio between equity and debt (also called asset allocation). However, a new lesson that a rising market teaches is that keeping the portfolio at the desired level takes work and ‘rebalancing’ the portfolio is as important as making the asset allocation.But, without active rebalancing, the financial plan goes awry. Understanding rebalancingRebalancing is simply the strategy to sell the winning asset class and buy the losing one to keep coming back to the original asset allocation, assuming that nothing has changed in the individual’s circumstances mandating a change in this allocation. This means investors should have been selling equity and buying debt in the last few weeks. Consider this example: a Rs 10 lakh portfolio is to remain equally divided between equity and debt, that is a 50:50 asset allocation, but a rising stock market takes the value of the Rs 5 lakh in equity to Rs 10 lakh, bringing the total portfolio to Rs 15 lakh. The asset allocation has now changed without the investor doing anything, to 67:33. He now holds 67 per cent of assets in equity, while he began with wanting just 50. In such a situation, financial planners worldwide advocate rebalancing the portfolio by reducing the equity part and increasing the debt part, till the original 50:50 is reached. When to rebalanceFinancial planners are fairly consistent with their advice: rebalance periodically (quarterly, half-yearly or annually) or when the portfolio gets 5 per cent out of whack. This is one of those times when most portfolios are skewed away from the original allocation due to the boom in equity. “This is the best time to rebalance,” says Sanjeev Bajaj, Director Bajaj Capital. Bajaj has been advising his clients to sell equity for some time now — at Sensex 6,200, at 6,400 and then at 6,600. Agrees Himanshu Kohli, Partner at the Gurgaon-based financial planning firm Client Associates: “We are advising our clients to rebalance and reallocate their portfolios away from equity”. How to rebalanceThere are two ways to do this: One, investors can sell the rising asset class (today, that is equity) and buy the losing or stagnant one (today, that is debt) till the portfolio is back at the original asset allocation. In the current market, for example, Bajaj follows a ‘bottom-up’ strategy. “The investor may have five stocks in, say, the information technology sector. We begin selling from the bottom of this pile.” Large-cap companies that are market leaders are less volatile than mid-cap companies, so when the market falls, the mid-caps fall harder and when they rise, they rise faster. Bajaj’s rebalance strategy aims at selling stocks with the higher Betas (a stock with Beta more than one, rises faster than the market average and falls faster too, and therefore is more volatile) in each sector first. This approach however, involves paying out capital gains tax and involves a transaction cost. Two, the fresh investments can go towards rebalancing, with most of the fresh money buying the losing asset class. There are several advantages of doing so: one is the emotional cost of selling the winning asset class makes people reluctant to rebalance. The second is the cost of rebalancing can be fairly high. Kohli prefers this strategy to the first one. “There is a capital gains tax to be paid when you sell a winning asset class and a transaction cost to buy and sell. This approach works to reduce the cost of rebalancing”. Short-term capital gains tax is now 10 per cent of the profit, brokerage cost ranges from 0.2 per cent to 1 per cent and mutual funds have an entry and exit cost that ranges from zero to 3.5 per cent. Agrees Bajaj: “This is a better approach, but all clients may not have fresh funds to do so.” Managing emotions while rebalancingTheoretically rebalancing appeals to logic, but try selling your best performing stock in a market that is going up. According to Certified Financial Planner (CFP) Devang Shah: “It is managing the client expectation that is tough in a rising market.” He, (along with the other planners we spoke to), has found clients unwilling to rebalance their portfolios to stay with the optimal asset allocation. “Not only do people let their portfolios run on, they want to actually increase the allocation to equity in such a market, when they should be doing the reverse,” says Shah. A rising market makes everyone a market expert, but remember that rebalancing is important if you want to stay on track with your financial plan. If you don’t rebalance, the market will do it for you when it corrects. And that will leave you with unbooked profits.
