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 fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more, 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 takerRisk TakerRisk takers are investors seeking opportunities in the market volatility and risk a great deal in expectation of a high rate of return. Thus, they tend towards high-risk investments with a great potential for returns or a loss at the same time.read more) 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 a high return and has a good risk appetite will invest less in bonds and more inequity. 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 the 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.
- 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 appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more 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 the 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 of rebalancing will help to achieve the desirous level of return.
- Rebalancing will mitigate unwanted risks.
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For eg:
Source: Portfolio Rebalancing (wallstreetmojo.com)
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 the 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 into 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 toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more 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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