Asset Rebalancing: The need of the Hour

After a continuous rally of almost five months finally equity market fallen this month. The BSE Sensex fallen by 4% (approx.) or 1362 points from 1st August closing to 31213 on 11th August 2017.

This makes us realize the real truth of the equity market that we should not expect that it will rise continuously. Over a longer period it may rise but in short duration market is always volatile and it will keep on going up and downs. So what is the solution for this, how should we invest in this kind of situation?

What is an Investment : An investment is putting money to get more money in future it can be by three ways. Firstly, lending money to someone who pays interest on it, be it a business or the government. Secondly, becoming a part-owner of a business, as in having a share in it. Thirdly, by buying something that may become more valuable in future, like gold, art works or real estate etc.

Asset rebalancing is the investment technique which can provide us balanced approach for investments. As mentioned there are two types of financial investments, one is equity (shares) and other is fixed income (deposits, bonds, etc). Here as we all know that Equity has higher potential to rise but carries more risk, while fixed income gives lower but steady gains. We are not discussing third option as they do not give any regular returns and it is very difficult to predict their values for future. We should design our investment portfolio depending on our needs. Actually we should be investing in both (equity & fixed income) asset classes at a particular proportion which is called as an Asset Allocation. However over a period of time, equity and fixed income grow at different rates, hence disrupting the initial asset allocation. Therefore to rebalance the portfolio we may be required to shift money from one asset class to other one.

So what is the Ideal Portfolio: Well it is difficult to give any ideal number however it can be 50% +/- 10% of total portfolio depending upon a person’s need, and risk appetite. Historically we have seen that this kind of portfolio can give higher returns with lesser volatility. The simple logic for distributing our investments in both asset class is that as both are fundamentally different but complementary also. So in terms of the conflicting need of investments to get high returns as well as safety, each plays a role that compensates for the other's deficiencies.

So how it helps: When the markets fall, the 50% allocations portfolio will fall much less than the 80-90% of pure equity portfolios. Agreed that they also rise less when the markets recover, but that's fine because they have fallen less initially. There are studies which shows that to compensate one Rupee loss a person needs three to four Rupee gains, i.e. loss is more painful than the joy we get by profits. So portfolio allocation not just balances the returns but psychologically also it helps a person to feel much better as his portfolio falls less compared to full equity portfolio.  By portfolio allocation we are more likely to stay invested in bad times due to less losses. For example during the crash of 2008-09, we would have lost nearly 60% of our value, from the January 2008 peak of the market to the March 2009 bottom. However, in the 50% equity option, the losses would have been limited to around 30%.

So how to rebalance our Portfolio: As we all know that equity grows faster than debt, but is much more volatile and also falls sharply as compared to debt instruments, so the best way to protect our self and take advantage of the fact is to decide on a percentage balance between equity and debt, and sticking to it by periodically shifting money away from the one that becomes high to the one that becomes low. When equity is growing faster than fixed income-which normally happens most of the time—we should periodically sell some equity investments and invest the money in fixed income to restore the balance. When debt starts growing faster, we should sell some of our fixed income and move it into equity. While this sounds like a difficult thing to implement, but there are few mutual funds which do it themselves so it makes our life easy.

Every human needs variety in all parts of life be it food or clothes or vehicle or job etc. Similarly we cannot invest in just one asset class we need to allocate our portfolio in different asset classes so as to diversify our risk as well as get the best out of them.