Source: BURSA ACADEMY | Published: November 2021
In order to have a functioning investment plan, it is important for you to include a technique called rebalancing.
Rebalancing refers to investment adjustments in your portfolio. It is a change in the asset allocation of an investor’s desired returns towards their portfolio. It realigns the weightage of an asset portfolio and includes the buying and selling of the portfolio’s assets to maintain a risk level.
This technique discounts emotions away from investment and helps investors to maintain their portfolio at its initial asset allocation. If the investor does not review the portfolio for a while, then the investor’s portfolio can be derailed from its original asset allocation, leaving significant gaps that can be mitigated through rebalancing, causing the portfolio to have a high exposure of risk volatility and impacting the returns by being less optimized.
The purpose of rebalancing is to protect the investor from highly exposed undesirable risks. It also helps the portfolio manager to keep the exposure within their scope. As there is no market that continually performs at its peak or pit, and economies and financial markets have their own cycles, rebalancing will help in buying cheap and selling high, making good returns over the years. In addition, age factor is also a reason to consider, when rebalancing. Studies suggest that many investors set up their investment plans in their 30s and 40s and never look into them again. These investors face a higher risk exposure over the years, given that the equities portion will likely grow over time. The principle for including age and asset allocation consists of holding ‘100 minus age’ as the equities percentage and holding the balance in bonds.
Other determining factors for rebalancing include investment goals, time horizon and risk profiles. All these need to be considered carefully as they will affect the optimization of the portfolio.
Rebalancing also helps investors to remain focused on long-term investment objectives. As emotional beings, people might use emotions to decide their investments, especially during high market volatility periods. In these moments, it could be difficult to stick to the investment goals and strategies as the markets might not move in tandem with expectations. This can lead to panic selling as a result of losing focus on long-term goals. The strategy of rebalancing can help reduce the stress relating to making investment decisions at such times. By periodically assessing and rebalancing their portfolio, investors can maintain self-discipline and remain focused on long-term goals regardless of market conditions.
Furthermore, rebalancing allows investors the opportunity to lock in unrealized gains in their portfolios. During a market uptrend, when investors rebalance their portfolios, they may notice asset classes that outperform their original asset allocation. Hence, the investor can trim the outperformed asset class and invest the gains into other asset classes like bonds.
Looking into the age factor for rebalancing, here are some general guidelines on what each age group would find useful to consider as they do a rebalancing strategy.
For the age group 25-35, 70 percent of the portfolio should be in equities with the rest in the debt market. It is also important to have some cash reserves.
For the age group 35-50, there will be more short-term goals like children’s education or purchasing a house. Hence, a balanced 50-50 strategy is usually used. A huge chunk of the portfolio may also be invested in debt, depending on the investor’s risk appetite.
For the age group 50-65, their major life goals should have been met and the retirement fund will be their priority. So, equity exposure should be minimal here. Again, based on the principle shared earlier on equity allocation of ‘100 minus age’, this guideline will help investors know what to do next.
Depending on the needs of the investor, rebalancing can be monthly, quarter or yearly. A standard way to rebalance is to go for it when the asset allocation has changed over 5%. As the objective of portfolio rebalancing is to reduce the risk of the investment portfolio, investors may also consider grouping investments into sectors to see if their portfolio is overweight or underweight.
Investors also need to know what type of portfolio they are into, in order to maximize the portfolio. A conservative portfolio includes lower-risk stocks such as fixed income and money market securities. For the moderately conservative portfolio, stocks that pay high dividends will be a main strategy. For the moderately aggressive portfolio, it usually is almost equally divided between stocks and bonds. Hence, the balance will have to be growth and income. Since the aggressive portfolio will have more equities, its value could be more volatile and fluctuating. As the main goal for this portfolio is to grow capital, investors will have to maintain the portfolio on a long-term basis to achieve good results. To diversify the risk, this portfolio can have some added fixed-income securities.
Rebalancing does come with a cost, of course. It includes exit loads, time, labour, brokerage charges and even taxation. This is because when the stocks are sold, transaction charges are implied. As for fixed income options, they may also incur costs in the form of lower interest rates or penalties for foreclosing a bond. The costs are usually included in the advisory fees for managed portfolios. The best way to rebalance a portfolio is through the use of dividends, interest payments, or realized capital gains since there is no need to incur extra transaction costs. By transferring these cash flows into a money market account, investors can use the proceeds on the underweight asset classes as part of their rebalancing strategy. Another way to reduce the cost is to rebalance to an intermediate asset allocation rather than the target asset allocation. For example, investors may want to reduce the transaction size by investing in one asset rather than multiple assets if the cost of commissions or taxes is significant or the allocation amount is minor.
Do bear in mind that rebalancing is not the same as reallocation. Rebalancing adjusts the portfolio to keep it in sync with the investor’s risk level. For example, let’s take an investor with an asset allocation of 60% stocks, 20% bonds and 20% cash. If the stock portion outperforms and pushes the 60% stocks to 80% stocks and 10% bonds, then the investor might sell some of the stocks and buy bonds to get the portion realigned.
As for reallocation, it adjusts the asset allocation to totally change the risk level. For example, an investor started his portfolio in his late 20s with 80% stocks and 20% bonds and would adjust the asset allocation to 60% stocks, 15% bonds and 25% cash when the investor hits the age of 50. This reflects the change from an aggressive portfolio to a moderately conservative approach.
At the end of the day, the best strategy for rebalancing will depend on the portfolio manager or the investor’s goals. This is important as the costs involved need to be taken into account. Investors then need to take note of the factors involved when deciding the best rebalancing strategy for their investment portfolios.
Tags: EQUITIES
