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Portfolio rebalancing is the process of bringing the different asset classes back into proper relationship following a significant change in one or more.More simply stated, it is returning your portfolio to the proper mix of stocks, bonds and cash when they no longer conform to your plan. An example might help.
Say you have determined that given your risk tolerance, time horizon and financial goals that your portfolio should look like this:
• Stocks 60% Rs. 60,000
• Bonds 35% Rs. 35,000
• Cash 5% Rs. 5,000
• Total 100% Rs. 100,000
We’ll use a starting total portfolio value of Rs. 100,000 so the math is easy and the Rupee and percentages match.
How Things Change?
A couple of your stocks catch on fire and before you know it, your portfolio looks like this:
• Stocks 67% Rs. 80,000
• Bonds 29% Rs. 35,000
• Cash 4% Rs. 5,000
• Total 100% Rs. 120,000
You might be asking, ‘What’s the problem? You are up Rs. 20,000 – isn’t that a good thing?’ Of course, it’s a good thing, however the problem is it has moved the investor away from the ideal asset allocation and possibly exposed him or her to more risk than is acceptable.
This is where the conservative investor will step in and bring the portfolio back to the original allocation.
How to Rebalance?
You can do this several ways:
i) You could sell off some of the stock that had the recent run up and invest the profits in bonds and cash until the original percentages are achieved.
ii) Another alternative would be to look at your other stock holdings and sell any underperformers to generate the cash to invest in the other two asset classes.
iii) The third alternative would be to invest new money into your portfolio in the bonds and cash portion to bring those percentages up to proper levels.
It would be tempting to leave the portfolio alone, however the purpose of establishing an allocation is to achieve the best return with an acceptable level of risk. Doing nothing violates that premise and exposes the investor to unacceptable levels of risk.
As a rule of thumb, when your assets drift 5% or more away from your allocation, you should re-balance. This can occur naturally over time or following an abrupt rise or decline in one or more asset classes.
Look at Your Stocks
Re-balancing is not just a big picture exercise. Within the stocks portion of your portfolio, you may need to rebalance those relationship also.
For example, you might determine the stock portion of your portfolio should look like this:
• Large-cap growth stocks 50%
• Utility stocks 30%
• Technology stocks 10%
• Other stocks 10%
If several technology stocks takeoff in a big way, you face a dilemma. Do you sell off some of your winners and buy more of the other categories to rebalance your portfolio?
The other alternative is to put more money into the other stock categories to bring their percentages up and the portfolio back into balance.
The Price of Inaction
What is the price of doing nothing? If you are risk adverse, a portfolio that becomes more heavily weighted in volatile technology stocks will keep you up at night.
Consider what happened to many investors during the technology stock boom of the late 1999-2000 or real estate boom of 2007-2008. Not only did they let the technology stocks or reality stocks grow out of any reasonable allocation, many also sold off other stock to buy more such companies.
When the market crashed in March of 2000 / Jan of 2008, the investors who had let technology / real estate balloon to a hugely disproportionate percentage of their portfolio had nothing to fall back on.
Portfolio rebalancing is an important part of sticking to your game plan. You should look at your portfolio at least once is six month in terms of rebalancing and more frequently if you have had a significant gain or loss in any asset class.
