What is Portfolio Rebalancing?
Portfolio rebalancing is a reallocation of the weight of portfolio assets and includes buying and selling of existing assets either fully or partially from time to time to maintain the desired level of return. Rebalancing can be industry or sector-specific or in combination. The portfolio assets can be a mix of bonds, equity and other stocks depending on the investors’ appetite for risk and return and movement and value of stocks.
Why Portfolio Rebalancing?
The portfolio is rebalanced from time to time so that investors can gain maximum return from the investment. The investor or fund manager shuffles the stocks in the portfolio so that the desired level of return and risk is maintained. This shuffling is done after careful analysis of stocks and a lot of decision making and experience is required. Wealth managers, Mutual funds, Investment bankers, who handle portfolio(s) involving a huge amount of money pay careful consideration in rebalancing so that they can deliver the expected level of return over the period of holding investments.
How Does the Rebalancing of Portfolio Works?
Like we discussed earlier, the portfolio is based on an investor’s risk appetite. An investor who is risk-averse (low-risk taker), will invest more in bonds and less in equity. The reason being bonds deliver fixed and periodic rate of interest and equity is volatile in nature. In such a case, the investor might end up investing around 70%-80% in bonds and balance 30%-20% in equity.
Similarly, an investor who wants high return and has a good risk appetite will invest less in bonds and more in equity. In such a case, the scenario is reversed and he invests 70%-80% in equity and balances 30%-20% in bonds. Again, if an investor wants to have an average return will end up investing 50% each in bonds and stocks.
Let’s understand this with Portfolio Rebalancing example.
Example #1
Erica is a small investor who has saved some money ($1,000) from her regular job to invest in the stock market and is an investor with an appetite for low risk and average return. In this case, she decides to invest 80% in bonds and balance 20% in equity stocks.
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- Bond – 80%*$1,000 = $800.
- Equity – 20%*$1,000=$200.
Equity is volatile in nature and will benefit from rising in value.
After one year, Erica checks her portfolio and finds that there is a 5% increase in bond value and a 10% increase in equity. Her new portfolio value is-
- Bond – $800*1.05= $840
- Equity – $200*1.10=$220
- Total value = $1,060
The weight of bond and equity have changed.
Situation 1: Erica is still risk-averse and she wants to maintain an 80:20 ratio of bond and equity again. In this case, to rebalance the portfolio, she will sell some equity and buy a bond so that the desired ratio is maintained.
Situation 2: Seeing that equities are performing better and are expected to rise in value in the future, Erica has changed her risk appetite and decides to invest 80% in equity and 20% bonds. She sells most of the bonds and invests that money to buy equity.
Example #2
Mutual fund manager pools in $10m from individual investors. He diversifies the risk in the portfolio by investing 50% in equity and 50% in bond. He also decides to further diversify the risk across different sectors in the percentage given below.
| Telecommunication | 10% |
| Real Estate | 10% |
| FMCG | 15% |
| Hospitality | 5% |
| Banking | 10% |
| Manufacturing | 5% |
| Oil and Gas | 15% |
| Pharmaceuticals | 20% |
| Information Technology | 10% |
The fund manager will review the performance on a regular basis but may decide to rebalance portfolio monthly, quarterly or yearly.
Advantages of Portfolio Rebalancing
- It helps us to balance the risk and returns from the stocks as per our investment strategy.
- It helps us to track and maintain our financial returns and expectations. A habit to rebalance will help to achieve the desirous level of return.
- Rebalancing will mitigate unwanted risks.
Disadvantages
- Frequent rebalancing leads to higher transaction costs. In many cases, net income is reduced due to the offset of higher costs. Experience and knowledge are required to understand how frequently portfolio needs to be rebalanced and if it’s actually required so that unnecessary transaction costs can be avoided.
- Rebalancing leads to cutting off the performance leg of stocks. The stocks may be removed from the portfolio before they fully come in their bullish stage.
- Wrong decisions can lead to higher exposure to risk.
Conclusion
As we have understood, portfolio rebalancing can be done for the smallest of funds to the biggest of them either by individual investors or expert portfolio managers. An investor can maintain any number of portfolios with different combinations of stocks and different risks and returns.
Rebalancing is a part of managing a portfolio and a major part of the decision relies on the risk tolerance of the investor. There are certain tools and software available for investors to track and monitor the performance of their stocks in a portfolio and guiding them to a better decision making like rebalancing, buying and selling.
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