Re-Balancing Uncovered

Re-balancing is the process by which an investor reverts back to its original asset allocation. This is done by redeeming the excess profits from the outperforming asset and investing in the one which is under-performing.

Why re-balancing is important?

The main purpose of re-balancing is to have a better control over risk and ensure that the portfolio is not heavily dependent on ups and downs of a single asset. To understand it better, let’s assume that you put Rs. 10,000 in a Equity mutual fund and Rs. 10,000 in debt mutual fund on 1st January 2018. At the end of the year 2018, your investment of Rs. 20,000 becomes Rs. 30,000 in value. Due to market forces, equity mutual fund went up and debt mutual fund went down and value at the end of the year 2018 was for equity mutual fund 25,000 and debt mutual fund Rs. 5,000. At the start of the year the investments were having same weights. However, at the end of the year equity mutual fund dominated the portfolio with around 80 per cent. If in coming years equity mutual fund performed badly, your investments may see a downturn in no time.

What are the different strategies of re-balancing?

There are various re-balancing strategies adopted differently by different people. Following are some of the re-balancing strategies:

Calendar Re-balancing

Calendar re-balancing is the most basic approach towards re-balancing. This strategy simply involves adjusting the investment holdings within the portfolio at predetermined time intervals back to the original asset allocation at desired frequency, then may it be monthly, quarterly, etc. 

Percentage-of-Portfolio Re-balancing

This strategy is focused on the percentage composition of an asset in a portfolio. Every individual asset is given their target weights along with corresponding tolerance level. For instance, if a portfolio consists of 70 per cent equity mutual fund and 30 per cent debt mutual fund with the tolerance level of +/- 5 per cent. Assuming the equity market having a bad time due to which the asset allocation changed to 60 per cent equity and 40 per cent debt. So, as it has crossed the tolerance level of 5 per cent, the portfolio would be re-balanced to bring it back to 70% equity and 30% debt.

Constant-Proportion Portfolio Insurance

The basic premise of this strategy is to maintain a minimum safety reserve held in either cash or liquid mutual funds. This strategy comes under investment for multi-goal strategy. For instance, an investor wants to invest Rs. 3 lakhs of which Rs. 1 lakh he wants keep insured for any emergency arising in the future and remaining 2 lakhs to be invested for a goal of buying a car.