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How periodically rebalancing your portfolio reduces investment risk?

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While risk management is recognized as a critical function for organizational stability and growth, its importance in personal finance is less discussed.

How periodically rebalancing your portfolio reduces investment risk?
While risk management is recognized as a critical function for organizational stability and growth, its importance in personal finance is less discussed. Just as an organization must take regular stock of its risk register, individual investors must also conduct a careful evaluation of their portfolio to mitigate risks. Other than managing risks, rebalancing a portfolio also helps to orientate it according to the investor’s priorities and timelines.
Rebalancing a portfolio usually involves buying or selling assets, keeping in mind the investor’s risk tolerance and investment goals. Risk tolerance is the degree of risk or variability that an investor can withstand. Investment goals are the returns one expects from one’s portfolio. Both these factors are subject to change and hence, the portfolio must be adjusted to accommodate the changing circumstances and expectations of the investor.
Starting with Asset allocation
Every portfolio management starts with an evaluation of various factors that decide asset allocation in areas like equity, debt, gold, fixed deposit, or real estate. The most important factor here is not the asset, but the investor’s risk profile. The long-term success of an asset portfolio can occur only when the asset allocation matches the profile. Every individual has a distinct risk profile which is made up of factors like their income, age, and the investor’s own leanings. People with higher disposable incomes will have more funds for investments than those with high liabilities. Similarly, those with stable income will have a higher risk capacity than those with variable income.
Age is one of the most important deciding factors in asset allocation, particularly when dividing the portfolio between stocks and bonds. Stocks are high risk but are likely to show higher returns in the long run when compared to bonds. Hence, the asset allocation for a person in his/her 20s or 30s may contain a higher percentage of stocks. Bonds, on the other hand, are more stable and hence, ideal for investors who are closer to their desired retirement age.
The third factor is the investor’s own learning or risk tolerance. It is the amount of risk an individual is prepared to tolerate psychologically and may not be reflective of their actual risk capacity. Depending on their risk tolerance, an investor can be categorized as an aggressive, moderate, or conservative investor. An aggressive investor will be unhappy with a conservative allocation that stresses long-term savings. On the other end of the spectrum, a conservative investor with an aggressive portfolio will be unhappy, unable to handle its volatility, and consequently, taking poor decisions that can lead to loss of wealth.
Rebalancing the Portfolio
Once the asset allocation is decided, we have the parameters within which the portfolio can be juggled. There are different methods of balancing one’s portfolio. Broadly speaking, we can separate them into two categories, strategic rebalancing and tactical rebalancing. Strategic rebalancing focuses on the long-term goals, maintaining the proportion of the original portfolio. Although this is seen as a passive ‘hands-off’ approach, in reality, it requires regular monitoring and maintenance. For instance, if the ratio of equity to fixed income assets in the original portfolio was 60/40, the same proportion must be maintained throughout its lifecycle.
Tactical rebalancing is more active. The goal here is to manage the assets in the short term by focusing on minimizing the risk exposure while pursuing new opportunities. Although it also follows a targeted asset allocation, it offers the investor more flexibility in terms of juggling between asset classes. In the strategic approach, we are more likely to follow a conservative pattern of ‘buy and hold’ whereas tactical investing allows you to tweak your portfolio on a more immediate basis.
The purpose of periodically adjusting a portfolio is to ensure that the investor’s risk profile matches with their asset allocation over a long period. While it must reflect their risk capacity, it must also be tailored according to their risk tolerance to ensure that the level of risk is neither too high nor too low. Over time, and with disciplined rebalancing, one can learn the instinct of buying low and selling high. In the short term, they will be trimming their winners and buying a lower-priced asset, which may seem counter-intuitive. However, in the long-term, they will slowly start building up their assets that show higher appreciation and hence, create more wealth. Rebalancing also helps in inculcating financial discipline as it hinders focusing on only winners at the cost of assets that may be going through a temporary lull.
A successful investment portfolio is as much about asset allocation as it is about managing behaviors and risks, and periodic rebalancing is the best way to identify, monitor, and mitigate associated risks, to build a diversified and wealth-generating portfolio.
The writers, Hersh Shah and Pratik Oswal, are CEO, IRM India Affiliate and CEO, Glide Invest, Head - Passive Funds, Motilal Oswal AMC respectively. The views expressed are personal
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