Building an investment portfolio is one thing, and managing it well to mitigate risks and ensure good returns is quite another. With rising inflation and volatility in stock and bond markets, it is the fine art of rebalancing of portfolios that can protect them. However, as is often the case with many of us, emotions, especially fear and greed, tend to take over and prevent us from taking the right steps in time. An extraordinary year in equity markets might give excellent returns but remember it also pushes the risk level high.
“Goals change over time, and rebalancing helps you to adjust the portfolio to your needs. For example, the investment portfolio of a 22-year-old looks different than the portfolio of a retired person at 69. The youngster wants capital to grow, whereas the older person is looking for preservation of the capital and probably some income as well,” says Peter Siks, investment coach at Saxo Bank.
Vijay Valecha, chief investment officer at Century Financial, adds: “Periodic portfolio rebalancing is essential for maintaining your target asset allocation, mitigating risk, and enhancing long-term returns. As time passes, the performance of various asset classes can fluctuate, causing your portfolio to deviate from its intended allocation. Rebalancing corrects this drift, ensuring alignment with your risk tolerance and financial objectives. It also minimises risk by preventing overexposure to any single asset class or sector.”
Moreover, rebalancing can boost long-term returns by compelling investors to sell high-performing assets and acquire undervalued ones. “This approach allows one to capitalise on gains and potentially purchase assets at more favourable prices. A systematic rebalancing approach fosters discipline, reducing emotional influences on your investment choices and can be done tax-efficiently by selling assets with lower capital gains or losses,” adds Valecha.
Even though rebalancing is one of the aspects of portfolio management that has strong theoretical justification, it is still one of the most overlooked aspects by common investors. One reason is the lack of awareness of its merits.
How often should it be done?
The frequency of portfolio rebalancing for retail investors hinges on several factors, including their investment goals, risk tolerance, and portfolio assets, explains Valecha. “While there’s no one-size-fits-all solution, some general principles can guide the decision on when and how often to rebalance a portfolio. For retail investors with long-term objectives and stable risk tolerances, an annual or semi-annual rebalancing strategy is often adequate. This periodic approach preserves the portfolio’s alignment with the target asset allocation while minimising transaction costs and potential tax implications. Alternatively, some investors prefer a threshold-based rebalancing approach. They rebalance only when the portfolio’s asset allocation deviates by a specific percentage from the target allocation, reducing the frequency of rebalancing and guarding against impulsive reactions to short-term market fluctuations. A time-based rebalancing schedule, such as quarterly, can also be effective in enforcing discipline and maintaining the intended allocation.”
Additionally, tactical rebalancing based on changing market conditions or life events may be necessary. When significant life changes or shifts in financial goals occur, it’s prudent to review and potentially adjust the portfolio to align with the new circumstances.
Keeping costs low is also one of the pillars of success. “The approach taken can be time-dependent (once a year, which is for most investors enough) or bracket-dependent. In the latter, the methodology is to set certain maximum and minimum asset allocations for stocks. For example, the default percentage for stocks in the portfolio is 50 per cent. If this percentage is below 40 per cent, stocks will be bought, and if this percentage exceeds 60 per cent, stocks will be sold,” says Siks.
Fine art of letting go
One of the trickiest aspects of investing is judging when an investment, whether it is a fund or a stock, can be deemed an underperformer and when to exit. Clearly, multiple factors need to be considered to make that choice.
“An investment is deemed an under-performer when it consistently lags behind its benchmark or peers. The duration an investor should wait before exiting such an underperforming investment varies, contingent on their investment objectives, risk tolerance, and the specific characteristics of the investment. Evaluating the investment’s fundamentals is crucial. A deterioration in key factors like revenue growth, earnings, or the company’s competitive position, which initially attracted the investor, may indicate under-performance. If the company maintains strong fundamentals and a solid track record, they may choose to hold the investment longer. Conversely, if they perceive a fundamental issue or are uncomfortable with the risk, they may opt to sell sooner,” advises Valecha.
The time horizon of investment is vital. “Short-term under-performance may not be concerning if the investment aligns with long-term goals. However, persistent under-performance over an extended period, failing to meet objectives, is a cause for concern. What constitutes under-performance depends on the investor’s specific financial goals, such as capital preservation, income generation, or capital appreciation,” adds Valecha.
An investor’s sensitivity to under-performance is influenced by their risk tolerance. “If the risk-reward profile of the investment changes significantly – for example, due to increased volatility, high fees, or management changes – exiting may be prudent. Determining whether under-performance results from a temporary setback or a fundamental business problem is crucial. In essence, recognising underperformance and deciding when to exit depend on a holistic evaluation of the investment’s performance, aligning with the investor’s financial objectives, risk tolerance, and the broader market context,” says Valecha.
When investing in equities, one would do well to learn how to distinguish between a stock’s valuation and its price. Price signifies the current market value, while valuation indicates intrinsic worth based on financial metrics and potential. To grasp this difference, start with the basics: understand that price and valuation are distinct, where price is what you pay in the market, and valuation is the true or perceived worth based on financial factors.
“Fundamental analysis is a key starting point. This method involves examining financial statements, earnings reports, and other peer valuation metrics to gauge a stock’s real value versus its market price. Comparing a stock’s price to historical levels, peers, or market indices is a practical approach. If it’s trading below historical averages or industry peers, it may be undervalued. In addition to quantitative analysis, consider qualitative aspects like a company’s competitive position, management quality, and industry trends. These factors significantly impact a stock’s valuation. Understanding market sentiment and behavioural factors is crucial. Emotional trading can cause stock prices to deviate from their intrinsic values,” says Valecha.
“The basics of this distinction are the fundamentals of the company and development of the revenue, EBITDA, profit, market share, estimated growth of the market, interest rate sensitivity of a certain business and so on. Being able to form an opinion about the future is the basis of success. It helps if you, as an individual investor, understand the business the company is in. This enables you to do a reality check on the projections of the market (share) in 3 to 5 years,” says Siks.
Whatever approach you choose, remember that the burden of management and trading costs arising from rebalancing rises sharply the more frequently it occurs. A six-monthly or annual rebalancing strikes the best balance between portfolio efficiency and cost minimisation.
Suneeti Ahuja-Kohli is an independent journalist based in Dubai. She can be reached at email@example.com
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