It is often said that investing is an art. One often thinks that the job of prudent financial planning is over by making regular savings. However, it is easier said than done since it is not only about saving but also saving and investing money in the right pockets. Markets today provide a wide range of investment options to investors across different asset classes. Still, one tends to go overweight in a single asset class, thereby creating a skewed investment portfolio. While a young investor tends to trust equities to the core, a conservative investor may trust bank deposits to park their savings. However, instead of going overweight in a single asset class, one should focus on a prudent asset allocation strategy, i.e. an investment strategy that aims to build the right balance of asset classes within the investment portfolio.
Since different asset classes generally run through different return cycles across different times and have different associated risks, having an investment portfolio spread across different asset classes mitigates risk. As such, asset allocation is the key to risk-adjusted long-term wealth creation. It is a function of the investor's return expectations, investment horizon, and risk appetite. For example, an investor with 30 years for retirement can have a more significant allocation towards equities. Similarly, an investor nearing retirement age may wish for more safety in the investment portfolio with a more significant allocation towards debt. Deciding the optimal asset allocation might be tricky for the investors, but it should be tested periodically once done. Accordingly, portfolio rebalancing needs to come into the picture.
Portfolio Rebalancing
It is the rebalancing exercise carried out to maintain the asset allocation to an optimal level. While an investor may have invested with its optimal asset allocation levels in mind, the balance between the portfolio asset allocation and targeted asset allocation remains dynamic and may change over time due to various reasons:
- Changes in Investment Performance – This is an inherent reason the portfolio requires periodic rebalancing. When invested in different asset classes, the investment performance is not bound to remain in line with the expectations. The portfolio returns may impact the asset allocation and shift it out of alignment from the targeted asset allocation. For example, an investor had targeted 70% equity and 30% debt for his investment portfolio towards long-term goals, thereby investing Rs. 70 towards equity and Rs. 30 towards debt for an investment portfolio of Rs. 100. However, the equities generated 20% returns post one year, while debt valuations remained at almost similar levels. As a result, the portfolio valuation after one year went to Rs. 84 for equity and Rs. 30 for debt, resulting in the asset allocation of 74:26 for equity and debt. To maintain the targeted asset allocation, the investor would need to sell 4% equity and invest in debt. However, the asset allocation exercise must be done at reasonable intervals and should not lead to frequent churning or higher portfolio turnover.
- Changes in Investing Preferences – The investing preferences of the investor also tend to change over time with experience and also due to changes in risk appetite. For example, an investor had concluded 50% equity and 50% debt to be an ideal asset allocation considering his risk appetite and made investments accordingly. However, with more experience in financial markets, he got more confidence in equity markets and decided to have a more significant allocation of 75% towards equities for long-term goals. Accordingly, the investor will sell/ liquidate some part of its debt portfolio and invest the same in equities so that the resultant asset allocation is 75% equity and 25% debt.
- Changes in Financial Goals – Financial goals might change, wherein the corpus requirement may lower or increase. For example, an investor was investing towards the goal of house property for Rs. 3 crores after ten years. However, due to the slump in the real estate market, the goal amount has now been reduced to Rs. 2.5 crores. In such a case, the investor may lower the investment amount per month or consider lowering the investment portfolio's return expectations by increasing the debt allocation. Debt tends to provide relatively stable and reasonable returns to the investor. The investor may need to partially liquidate equity investments and invest the same in the debt portfolio to maintain the targeted asset allocation.
- Attractive Market Valuations – Market valuations may require the portfolio to be rebalanced appropriately. A universal investment mantra when investing in equities is 'buy low, sell high'. When the equity markets are trading at relatively inexpensive valuations, one should aim to allocate higher equities to benefit from prevailing valuations. Similarly, when the markets are trading at somewhat higher valuations, one should aim to book the profits earned and shift allocation towards cash/ debt to prevent portfolio downside during market corrections. While an investor may do such portfolio rebalancing manually, dynamic asset allocation funds also provide a similar investment strategy and maintain dynamic asset allocation based on market valuations.
When should the Portfolio Rebalancing be done?
One should target portfolio rebalancing at regular intervals, at least once every year. Further, portfolio rebalancing based on market valuations may be required to be reviewed more precisely, which the investors may also delegate by investing in dynamic asset allocation funds.
Things to consider while rebalancing the portfolio
While undertaking a portfolio rebalancing exercise, one should consider the exit load implications and tax incidence. Some mutual fund schemes carry an exit load to be paid by the investors if the units are redeemed before the specified period. Such exit load is levied on the redemption NAV, and accordingly, it directly impacts the overall portfolio returns. Hence, one must pick up those mutual fund units for redemption and rebalancing that have completed the specified holding period so that no exit load implications exist.
Similarly, the point of taxation for gains from mutual fund investments under the Indian Income tax laws is when such gains have been realized on redemption of mutual fund units. As such, any redemption undertaken to rebalance the investment portfolio will attract tax incidence on the profits realized. If one has rebalanced the investment portfolio or liquidated the mutual fund investments, one should take care of such compliances while filing their Income Tax Return (ITR).
Note: The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the investment date.
