All of us deliberate how to create a portfolio to achieve our investment objectives. It’s not often that we pay equal attention to managing this portfolio through its investment horizon. Thought in practice this process is difficult, as it requires adjustments based on market conditions.

In this article, we will discuss two issues related to retirement portfolio. One, why managing your retirement portfolio through its investment horizon is important, and two, how you can apply certain rules to manage your portfolio.

Staying focused

Creating a retirement portfolio is only the first step. Problems compound thereafter.

What if the stock market declines during the initial years of your investment? Remember, 25 per cent loss on your portfolio hurts you more than a 25 per cent gain. Because it requires 33 per cent increase in your portfolio value to regain a 25 per cent loss.

Your portfolio has to just decline by 20 per cent to give-up 25 per cent unrealised gains. You can reduce this risk by reviewing your portfolio periodically. Specifically, if you require a return of 11 per cent every year to achieve your investment objective, and your portfolio has unrealised gains of 15 per cent in any year, you should take profits to the extent of 4 percentage points. This way, you only risk the required investment capital to achieve your objective.

But there’s another problem. Even if you adopt the method suggested above and take rule-based profits on your equity investment, your portfolio could still lose significant value towards the end of its investment horizon. You will fail to achieve your objective because you will have little time to recover losses.

Fortunately, lowering equity allocation in your portfolio through the rebalancing process can help you moderate investment risk as you near your retirement date. The question is: How should you rebalance your portfolio?

Rule-based rebalancing

For most part of your working life, the proportion of your equity investment will fall between 50 and 75 per cent. You should typically have not more than 25 per cent equity investment in your portfolio on your retirement date. There is a trade-off. Equity provides the opportunity to earn higher returns. So, you might want to have higher equity allocation during your peak career for two reasons. Your earnings will be higher, and this is also the time when you’re likely to significantly reduce your debts. Both these factors improve your savings and returns potential.

To balance the need for higher returns with the requirement to lower risk, you should reduce your equity allocation starting age 45 and complete the rebalancing process by 55. As a general rule, you can reduce your equity allocation at an increasing rate. That is, at 45, you can cut your equity investment by 10 percentage points to 65 per cent. At 50, your equity investment could reduce by 15 percentage points to 50 per cent; at 55, you could halve your allocation to 25 per cent of the total portfolio.

You can choose to reduce your equity allocation on a continual basis during the three five-year time buckets. That is, you can spread the 10 percentage-point reduction over five years, between age 40 and 45 and likewise for the other time buckets. You have to review your investments periodically to stay on course to achieving your goals. This is because the actual market conditions over the investment horizon can be different from the assumptions made when you created your portfolio. At the extreme, the difference between actual and expected returns can lead to failure of objectives; it would lead to giving up unrealised gains in the portfolio and at worst, losing the investment capital. Portfolio rebalancing can reduce this risk.

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