A major process relating to self-management of your investments is portfolio rebalancing. In this article, we explain why rebalancing is important. We also offer a simple rule to rebalance your portfolio through the time horizon for a life goal.

Managing risk

Every goal-based portfolio should have a combination of equity and bond investments. Your equity investment should be in large-cap ETFs and your bond investment in bank recurring deposits. Asset allocation refers to the proportion of equity and bond investments in your portfolio. Your equity investments will carry unrealised gains (or losses). So, the proportion of equity in the portfolio will vary very year. If unrealized gains from equity is greater than the returns on bank deposits, the equity allocation will be higher than in the previous year. This may require you to adjust the asset allocation to reduce the risk associated with equity investments. This process is called rebalancing.

You must also be mindful of your portfolio’s risk as you approach the end of the time horizon for a life goal. The more the equity allocation, the greater the risk. This is because a decline in your equity investments towards the end of the time horizon for a life goal would allow limited time to recover the losses. You should cut your equity allocation as your approach the last five years of the time horizon for a life goal. This means you must sell some of your equity investments and move into bonds, another reason to rebalance your portfolio.

Conclusion

The rebalancing rule to manage risk relating to unrealised gains is simple. Suppose you expect a 12% annual pre-tax return on equity. If gains on your equity investments are greater than 12% in any year, you should take out returns above 12%. Assume you have 10 lakh in equity and your annual unrealised gain is 14%. You should redeem units worth 2% of 10 lakh and invest the amount in fixed deposits. What about rebalancing to reduce risk as your approach the end of the time horizon for a life goal? Your peak equity allocation should not be more than 70% five years before the end of the time horizon for a life goal. You must thereafter cut your equity allocation (say, 10% annually) so that you hold not more than 30% at the end of the time horizon for a life goal.

(The author offers training programmes for individuals to manage their personal investments)

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