Rebalance your portfolio occasionally for better gains

You may find that I correlate investments to driving often, but I do seek simple ways of explaining financial concepts. Portfolio rebalancing can sound complicated, but needs to be done regularly to ensure that one’s investments do not carry risks which are not proportional — neither too high, nor too low — to what one can bear.

So, imagine that while driving a car on the highway at 80 km per hour, you see a red traffic light 200 metres away. You can continue speeding with the slender hope that the traffic light will turn green by the time you reach, and risk a sharp brake if it does not.

Alternatively, you can move to a lower gear, reduce speed and come to a gradual halt as you approach the traffic light.

Rebalancing is the process of restoring your portfolio back to its asset allocation targets. This may become necessary since some of the allocations may fall out of alignment with the original target percentage allocations for various reasons.

By following a disciplined approach to rebalancing, you will find that your portfolio does not overemphasise or de-emphasise one or more asset categories of your portfolio.

When is rebalancing required?

Rebalancing may be required when:
a) positions have become too large or too small;
b) your financial goal(s) have been achieved;
c) your financial objective(s) have changed;
d) your time horizon has changed.

Is there a marked difference?

Let us study an example of a portfolio where you have decided to invest 50% in equities, 40% in debt, 5% in gold and 5% in real estate. You have also decided to rebalance the portfolio at the end of every year. In the past 10 years starting January 2000, your portfolio would have earned you 14.1% pa compounded annually (see table).

It was possible to book some profits in December 2007 and also take the plunge into equity in January 2009 when most others dreaded to tread. Instead of rebalancing, had you invested Rs 100 in January 2000 and stayed put, your portfolio would have grown to Rs 295, or a cool 20% lower than the rebalanced portfolio.

We are not saying that an annual rebalancing is essential: we are highlighting the benefits of this process. So, as you approach the traffic light at a slower pace, and the light turns green, you get the advantage of revving up your car from second gear itself instead.

You do realise that this gives you a headstart to reach your destination faster, with less tension and definitely better fuel efficiency.