Rebalancing is as important as investing. You can do it once a year, or when your asset allocation deviates from your original plans.
After a few years of investing in mutual funds, investors come face-to-face with two problems. The first is when and how to rebalance their portfolios?
The second is how to clean up their portfolio and reduce the number of schemes.
While you can always try and do these two things independently, let’s try to understand how you can hit both these targets with one stone.We shall take a simple example to explain this. Suppose you started investing with a 60:40 equity-debt allocation. But after 2-3 good years for equities, your allocation has run up to 74:26. In simple words, the 60 percent of your equity allocation has grown in value, thanks to the growth of markets, and equities now comprise 74 percent of your portfolio.
Also, since you have been investing for several years, you have somehow ended up with 11 equity funds and four debt funds in your portfolio.
As you already know, rebalancing is about reviewing and restoring the originally chosen target asset allocation.
In this case, equity has grown to 74 percent of the portfolio and hence, you may want to bring it back to 60 percent. That means selling 14 percent from equity and putting that money in debt.
There are 3 ways to rebalance:
#1: Periodic rebalancing
This could be done once a year. Some do it half-yearly. But for most, doing it once a year is good enough.
#2: Deviation-based rebalancing
This is triggered if your allocation deviates more than a pre-defined tolerance band. Let’s say the tolerance band is +/-5 percent. So, in a 60-40 scenario, if your portfolio goes below 55 percent or above 65 percent, then it will have to be rebalanced.
#3: Combine the best of both worldsThe third option is to combine the above two. The investor reviews periodically (let’s say half-yearly), but rebalances only when it deviates more than the tolerance band. This is the best option in my view.
Coming back to our example. The portfolio has moved from 60-40 to 74-26 and needs to be rebalanced. Since every portfolio is unique, here are some broad guidelines on how to rebalance your portfolio.
Do you really need so many large-cap funds?
There is enough empirical evidence to suggest that it is getting tougher for large-cap funds to beat their benchmark indices. Take a look at how much you have invested in large-cap funds. And how many such funds you have in your portfolio.
You might want to gradually exit active large-cap funds. It makes sense to have large-cap exposure via index funds only. In any case, most active large-cap and index funds have overlapping portfolios. So, it’s better to gradually get rid of them and just keep 1-2 index funds for large-cap exposure.
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