Rebalancing equity portfolio more frequently reduces risk, but raises costs

Adopt an approach that you understand and can adhere to in the long run

In the last few days, Morgan Stanley, Goldman Sachs, UBS, Nomura and CLSA have called for booking profits in Indian equities citing rich valuations, a high probability of earnings disappointment, and pressures on margins, among other reasons. Many experts believe that rebalancing investment portfolios is the need of the hour primarily because the run-up in the stock market has altered investors’ asset allocation, making their portfolios riskier than their profile permits.  

Rishad Manekia, founder and managing director, Kairos Capital says, “Right asset allocation according to your risk appetite and time horizon is the key and you should focus on maintaining it.”

The question is when and how to rebalance. There are various ways to rebalance your portfolio based on your need, and expertise, such as corridor method, calendar method, constant proportion method, and so on.

Calendar method

This is the simplest approach to rebalancing. Pankaj Mathpal, Mumbai-based certified financial planner (CFP) says, “Investors must review their portfolios periodically, say, once a year, and rebalance it to the original allocation as decided initially.”

In this strategy, investors should check their portfolios at predetermined intervals and adjust them to the original allocation. While rebalancing once a year is good, doing so once every six months is better. Behavioural finance experts suggest linking this activity to special occasions, like a birthday or an anniversary, so that it becomes easier to  remember.  

The frequency of rebalancing should strike a balance between the investor’s risk tolerance (more frequent if risk appetite is lower) and the cost involved (higher frequency of rebalancing raises costs) in doing so.

Corridor method

Here, the rebalancing occurs when your asset allocation deviates by a certain percentage point from the original. Jharna Agarwal, head- products, Anand Rathi Preferred says, “Corridor method is the best re-balancing approach, provided you are mindful about exit loads and taxation.”

You could rebalance your portfolio whenever the weights change by a fixed value, say 5 percentage points. So, a 60:40 portfolio will be rebalanced when it becomes 65:35 or 55:45.

Mathpal adds, “Risk-averse investors may prefer this strategy. But it could lead to higher portfolio churn, and hence higher expenses and capital gain tax. It will help to control risk, but it will also limit growth opportunities because there will be frequent switching from faster- to slower-growing assets.”

Constant Proportion Portfolio Insurance (CPPI)

This is an advanced technique that more evolved investors may use. M Barve, founder, MB Wealth Financial Solutions, says, “This method is based on the premise that when an investor’s wealth increases, his risk tolerance also rises.”

This method allows an investor to decide how much he should allocate to equities in his portfolio instead of giving a breakdown of various asset classes and their ideal allocation ranges. Here, maintaining a minimum safety reserve is an important concern for the investor.  

Agarwal says, “Constant Proportion method suffers from the disadvantage that it does not take into account any fresh funds, goals or liabilities that may arise in an investor’s life.”

Mathpal adds, “This is not a very common practice due to psychological reasons. Most investors prefer the calendar rebalancing method.”

110 minus age approach

Subtracting your age from 110 gives the appropriate percentage of equity exposure you should have in your retirement account. The equity allocation that this rule suggests may be modified a little to take into account individual risk appetites. Following this approach will make your portfolio more defensive as your age advances, when the ability to recover from shocks typically reduces.

Experts say investors should adopt a rebalancing approach that they understand and can adhere to in the long run.

How CPPI method of rebalancing works
 

• The formula for determining equity allocation is: M*(TA−F)

• M is the investment multiplier and depends on risk appetite (higher for those with more risk appetite)

• TA is total asset in portfolio, F is floor value (minimum reserve that must stay safe)

• Suppose that total portfolio is Rs 60 lakh

• Minimum reserve required for a future goal is Rs. 30 lakh

• Multiplier is 1.5

• Initial allocation to equity, as calculated by this formula, will be Rs 45 lakh: 1.5*(60 – 30)

• Suppose that the market falls by 20 per cent

• The value of the equity holdings will be reduced to Rs 36 lakh (45 lakh*0.8)

• Total portfolio value now becomes Rs. 51 lakh (36+15)

• Portfolio is rebalanced applying the formula again

• New equity allocation will be Rs. 31.5 lakh [1.5*(51-30)].