Bears had their last laugh as the emerging market economies of India and China, went on a losing streak. Several arguments — from expensive valuation to high interest rates — can be given to support the decline in markets. Prior to that, India witnessed heavy inflows between June and November from foreign institutional investors (FIIs) taking the Sensex to 21,000 levels.

The markets are subject to positive and negative surprises. Even as retail investors in India are gradually warming up to the idea of equity investments for asset creation, the intermittent corrections often wards off the traditionally fixed-deposit-investing common man.

In that case, what should a layman do?

Let us suppose you made an investment in January 2001, during the dotcom bubble. In the last decade, your investment in an index fund that reflected the BSE Sensex would have fetched a CAGR of approximately 32 per cent. The price earnings ratio (PE) in 2001 was close to 21.42 times, which is higher than the average Sensex PE of 17 and the current PE of 19.8 times (source: BSE).

Despite entering at substantially overvalued levels, your portfolio has provided a decent return in 10 years and is clearly beating inflation. Therefore, it is important to stick to your investments and not hit the panic button.

But that does not mean one should stay put and not appraise the composition of one's portfolio.

Rebalance

Mr John Bogle, Founder, Vanguard Group of Mutual Funds, says, “The most fundamental decision of investing is the allocation of your assets. That decision has accounted for an astonishing 94 per cent of the differences in total returns achieved by institutionally managed pension funds.”

Rebalancing ensures that the risk-reward ratio in your portfolio is maintained and helps protect the downside, and takes advantage of the market situation.

Assess and rebalance portfolio composition when you are in short or excess of your investment objective; your life style changes; your risk tolerance level shifts.

External parameters may determine the per cent change in allocation — like capital market; macro-economic environment; transaction costs levied while rebalancing; and taxes.

Let us consider a few scenarios. For simplicity, we have considered public provident fund and equity mutual fund.

Scenario I: A 30-year-old is investing Rs 14,300 every month in his provident fund account to support a retirement corpus of Rs 10 crore. But is it adequate?

One should check whether the investment is giving adequate returns or not.

Let us say about 12 per cent compounded annual return is required every year.

Therefore, one may invest another Rs 14,300 in a midcap fund and monitor the portfolio accordingly.

When an individual is approaching retirement or planning a break from work, one needs more cash. Thus, the portfolio has to be rebalanced to an income generating fixed income product.

Scenario II: If your investment generates profits, marginal profit-booking and rebalancing is essential. Although the target return depends on your investment objective, market performance and deviation in returns also affect the intermittent allocation.

Greater the variability an individual is willing to accept more can be the deviation in the portfolio allocation.

Even if the markets delivered phenomenal gains, one can set a target return and re-invest into other asset classes periodically. This strategy serves as a hedge against the market crashes when the value of equity component may reduce drastically.

If an investor sells his equity holdings as the markets tumble; the person is not only losing money but is also moving away from the ultimate aim of investment — wealth creation.

Instead, investors can stagger and increase their allocation to the asset class as it corrects.

Illustration

We consider a portfolio that is subject to market returns between 2000 and 2010. In this calculation, we have assumed the 10-year G-sec yield and the average calendar year performance of large cap funds.

Static portfolio A comprising 50 per cent in fixed income and 50 per cent in equity has generated about 36 per cent annualised return at the end of 10 years.

If portfolio B was rebalanced in 2007, during the market highs, and profits worth 30 per cent were booked (the set target return) and re-invested into fixed income, the return from the investment portfolio at the end of 10 years would be 37 per cent.

Moreover, after the market crash, the portfolio value of rebalanced portfolio B was protected against the downside.

A similar rebalance in portfolio C done as early as the beginning of the bull run in 2004 would have delivered about 34 per cent returns at the end of 10 years.

Conclusion

The practice to review and rebalance your portfolio may seem quite irksome.

History shows that retail investors across the world miss the bus and enter the markets too late while the euphoria is at all-time peak.

When the going is good, investors sometimes do not like to change asset allocation. Aversion to loss causes panic selling amongst investors.

In this article, we have tried to suggest ways that investors should follow as opposed to the extreme and natural reactions. Just as there is no optimal portfolio, similarly, one can set no rules on portfolio rebalancing.

(The author is Managing Director, >Fundsupermart.com )

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