Rebalancing scenarios and rules – The Hindu

Why rebalance?

Rebalancing is the process of changing the asset allocation of your goal-based portfolios. Suppose you create your child’s education portfolio with an initial asset allocation of 60% equity and 40% bonds with a time horizon of 12 years. To keep the portfolio simple, let us suppose you invest in an ETF for your equity allocation and in bank recurring deposit for your bond allocation. So, the volatility in the portfolio’s returns can be primarily attributed to the equity allocation.

There are two reasons why rebalancing of this portfolio is important. One, you should reduce your equity allocation as you approach the time horizon for the goal. This is because any negative return in the equity market during the years approaching the goal can have a significant impact on your portfolio value and, therefore, on your life goal.

As a rule, for any life goal other than your retirement portfolio, it is best to apply the rebalancing process starting five years from the end of the time horizon for the goal. And two, your equity investments are exposed to the risk of losing unrealised gains.

Rebalancing can help you moderate this risk. The rebalancing rule can be determined thus: Arrive at a threshold return, which is one percentage point plus the expected pre-tax return on equity investments. When the actual return is greater than the threshold return, rebalance to the extent of the actual return less the pre-tax expected return. The rule for rebalancing is different for the two scenarios. But you may not have to rebalance every year, as you must trade-off two factors- the tax liability (typically, long-term capital gains tax) of rebalancing and the portfolio’s risk if not rebalanced. Note that the rebalancing rule for the second scenario already considers the tax liability by creating a threshold return. You could stagger the rebalancing process to reduce the tax liability for the first scenario. Here’s how: If two goal-based portfolios have entered the zone of rebalancing (five years discussed above), you may choose to rebalance one portfolio this year and the other the next year, depending on each portfolios’ excess returns. The objective is to make optimal use of any annual exemption limit applicable for long-term capital gains.

(The author offers training programmes for individuals to manage their personal investments)