When should you consider rebalancing your portfolio?

FII’s were the net sellers in Feb’22 to the tune of $4.7 billion, whereas DII’s continued to remain optimistic on Indian equities and were net buyers to the tune of $5.6 billion. India’s growth story continued with the GDP growth at 5.4% for Q3 FY22, mainly led by private consumption.

A combination of the 3rd Covid wave, rise in inflation, interest rate hike expectations and the Russia-Ukraine stand-off have been the major reasons for the current volatility. The ongoing conflict resulted in a sharp spike in oil and other commodity prices and risked disruption in the global supply chain. Despite the prominence of these events, plenty of other catalysts routinely cause markets to rally and reverse, year-in and year-out.

One of the key matrices that many investors use is portfolio rebalancing during such a volatile period. Portfolio rebalancing is nothing but moving closer to the initially decided asset allocation strategy.

The idea behind asset allocation is that not all investments are alike. You can balance risk and return in your portfolio by spreading your investment among different types of assets as different types of assets carry different levels of risk and potential for return and typically don’t respond to market forces in the same way at the same time.

A study conducted in 1986 by Brinson, Hood and Singer on the US pension fund substantiated that more than 91.5% of the variability of portfolio performance is attributed to asset allocation. A good strategy ensures that there isn’t too much deviation from the expected outcome.

The asset allocation strategy not only helps you achieve the return objective but also lowers the risk. Once the allocation shifts considerably – either in equity or debt, the expected rate of return differs as well as the risk by a considerable number.

For instance, if your allocation strategy as per the plan is Equity: Debt 60:40, and over some time (more than 18 months at least) this allocation moves more than 12-15% from the original allocation, you need to consider rebalancing your portfolio. Periodic monitoring is very critical in maintaining the pre-decided portfolio objective.

This is crucial to ensure that the risk-return matrices are also maintained. Basis the risk appetite and the time horizon, the asset allocation strategy is devised to reach the portfolio objective of the investor at a considerably lower risk, i.e. lower standard deviation. However, during a rally or a correction, this asset allocation strategy shifts, i.e. your allocation in equity or debt might not be the same that you had planned earlier and the expected rate of returns gets considerably affected, adding extra risk to the portfolio.

A study conducted, taking into account the most volatile periods, showed that the maximum drawdown in the portfolio, for example, during the 2000s recession crisis and the 2008-2009 crisis rebalanced portfolio, took half the time to recover as opposed to the one that wasn’t rebalanced.

This definitively establishes that portfolio rebalancing can not only enhance returns but also reduce risk and shorten the amount of time it takes your portfolio to recover following a bear market. It also helps to ensure that your investments remain properly allocated so that your portfolio is aligned with your long-term risk and return expectations.

All in all, the current market volatility may continue. While we might not have a very sharp V-shaped movement, markets should start to move into a positive trajectory in the medium to long term. Asset allocation impacts 90% of one’s long term returns, it also may bring about the perception of how assets have performed over a protracted tenure.

Thus for a long term investor, I would suggest they allocate time into strategizing and then following through with the plan with periodic monitoring and rebalancing their portfolio.

(Pradeep Gupta is the co -founder & vice chairman of Anand Rathi Group)