The first step in investment is to know your risk profile. Based on your risk profile, you create a portfolio. During portfolio creation, you invest in a different financial instrument in a specific ratio. We will understand it with an example later.
In a financial journey, creating the right portfolio is half the work done. To become a successful investor, you need to do portfolio rebalancing. Portfolio rebalancing is a process through which you can restore your portfolio to its target allocation. It is done by divesting underperforming/overperforming assets and investing in assets where the growth potential is higher.
Understanding portfolio rebalancing need
Let us assume you are an aggressive investor and decide to invest primarily in equity class with some allocation in gold. You have a good understanding of the market and stock selection – you can pick stocks across categories and invest in them. You decide to go with the below initial allocation:
- Large Cap stocks – 40% (Rs 40,000)
- Mid-cap stocks – 30% (Rs 30,000)
- Small-cap stocks – 20% (Rs 20,000)
- Gold – 10% (Rs 10,000)
You pick three to five stocks in each category and create a portfolio of Rs 1,00,000. After one year, some investments performed exceptionally well. But some investments performed below expectation. After a year, you evaluate your portfolio and find the numbers across categories as below:
- Large Cap stocks – 50,000
- Mid-cap stocks – 45,000
- Small-cap stocks – 35,000
- Gold – Rs 10,000
Your Rs 1 lakh has increased to Rs 1,40,000. The allocation now has changed to 36%, 32%, 25%, 7%, respectively. For this reason, you need to do portfolio rebalancing. Portfolio rebalancing ensures your portfolio is not dependent on the failure or success of a particular investment, fund type, or asset class.
How does portfolio rebalancing help investors?
You now understand the need for rebalancing. You must understand the reasons – why does it make sense to do it? Why can’t you let the portfolio run in auto-pilot mode?
Risk control – Stock market and stocks go through a boom and bust period. At certain times, some stocks move north, then they may fall and remain range-bound. For example, gold has given exceptional returns in 2019-2020. For the past two years, gold returns have been flat. You should exit stocks that have seen a boom and are now expected to fall – you book your profits and invest in other instruments that are likely to outperform the market in the future.
Market cycle – In a bull run, you should exit risky assets like equity after making good returns. Within equity, exit mid and small-cap stocks. You make a re-entry in the bear market again. With this approach, you will get better long-term returns. Portfolio rebalancing helps you achieve this.
Brings discipline – Many investors pick stocks and asset classes at random for investment. With portfolio rebalancing, you eliminate timing the market. You know automatically which asset to sell and which to buy, and when.
How to rebalance the portfolio?
Rebalancing is about selling one or more assets and buying other assets to bring the asset allocation to the original. In the above example, your percentage allocation in large-cap and gold has decreased. At the same time, the investment in mid and small-cap has increased. You will sell holding from these categories and invest in gold and large-cap stocks. After portfolio rebalancing, your portfolio allocation comes back to original. The assumption is that now the large-cap and gold will outperform the market.
Points to take care of while rebalancing
Tax implication – While selling assets, you should consider taxes. Avoid short-term taxes on the capital gains – hold your equities for more than a year. For long-term capital gain tax, you don’t have to pay taxes on capital gains up to Rs 1,00,000 – make use of it.
Frequency – You should not rebalance your portfolio too frequently. Ideally, once a year is the best option. Before the financial year ends is perhaps the best time to rebalance your portfolio.
Know the charges – Another reason portfolio rebalancing should not be done frequently is because buying and selling costs you additional bucks. Include those as well in your calculation. For mutual funds, check the exit load if you are selling the NAVs as part of the rebalancing.
Jarvis Invest and rebalancing
Rebalancing is about identifying and implementing a system that works best for you as an investor. Portfolio rebalancing requires some level of expertise. A novice investor or someone who does not track the market may not be able to rebalance portfolio – in the right way.
In our above example, you have to sell stocks from small and mid-cap categories. If you have five companies in each category, which ones will you exit?
You randomly cannot sell any stocks. To make the most of the equity market, selling the right stock is essential from your existing lot. Sometimes, you don’t have to sell any particular holding – selling a percent from each holding can also work. The bottomline is that it is not that easy.Jarvis Invest is an AI-driven platform that helps you create a stock portfolio. Not only this, but it also tells you what stock to sell and when. The tool checks thousands of data portfolios. Based on the results, it recommends which stock to sell from your portfolio. Start your investment journey with Jarvis Invest now.