A time to balance

Has the volatility of the past two months altered your risk tolerance level? Has the value of your stock portfolio declined alarmingly and been overtaken by bond assets, which have increased in size? In either case, your asset allocation needs a makeover.

The main challenge investors face is to earn a reasonable return while managing risk appetite. And maintaining your risk appetite means rebalancing your portfolio towards the desired asset allocation.

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As things stand today, should you choose more of debt or equity? That depends on your risk tolerance levels. Market conditions have changed in the past few weeks.

But a good asset allocation strategy can help you make prudent investing decisions. “The first step towards rebalancing your portfolio is to review what you expect by way of returns and weigh that against your tolerance for risk. The state of markets (equity and debt) also decide where you ivest and how much,” says Prateek Agarwal, VP & Head (Equities), Bharti AXA Investment Managers.

Balancing it right

Keeping a diverse portfolio means among different classes of assets (e.g., stocks, debt and liquid assets) so that they work together to build your wealth, while affording you some protection from downturns in any specific asset class. Says Arpit Agrawal, MD & Group CEO, Dawnay Day AV Financial Services: “Any asset class is impacted by three basic things— momentum, liquidity and fundamentals. In the short term, momentum and liquidity play a major role, but over the long term, fundamentals are more important.”

A balancing act How to construct a portfolio according to your age, risk and portfolio size. An asset allocation plan between equity and debt should ideally factor in your age¡ªthe younger you are, the more you should allocate to equity. According to a thumb rule, if you are 30, allocate at least 70 per cent to equity and vice versa. If your equity portion has gone too high, shift some of it to debt according to your original asset allocation. The market influences your asset allocation. Hence, rebalance your portfolio every year to avoid losses.

In times of volatility, especially when the markets are shrinking, savvy investors who stick to their asset allocation make the best of a disciplined approach.

During boom times, these investors book partial profits and add on debt, and during bad times in the equity market, they sell debt and add on equities to maintain the asset allocation equilibrium. “The idea behind this rule is to keep your asset allocation within the desired risk profile. During booming markets, most investors are tempted to add more to equities, rather than book gradual profits, leading to an asset allocation mismatch. This rule brings a greater sense of discipline for an investor and provides much needed guidelines for resisting greed and temptation in rising markets,” adds Ambareesh Baliga, VP, Karvy Stock Broking.

On the other hand, when the markets are booming, adding debt by sticking to your original asset allocation can reduce the volatility. Says Sanjay Matai, Promoter, Wealtharchitects.in: “Debt funds can help you counter volatility in the markets and provide a certain degree of stability to your holdings.”

When and why

Knowing how to rebalance your portfolio is half the battle; knowing when to rebalance is the other. One way to rebalance is to increase your investment in asset categories that have fallen below your original allocation percentages. Another is to sell assets in one category and use that money to increase your investment in categories that have become underweight. Says Agarwal: “I recommend that you take a look at your portfolio at least once a year and think about pruning any asset class that has moved beyond its target by more than 5 per cent.”

Let us assume that an investor buys units in various equity funds for Rs 7 lakh, and invests Rs 3 lakh in debt funds. The objective is to maintain a constant asset mix of 70-30 through the investment horizon. The problem starts when stock and bond prices change. The reason is that movements in these asset prices will change the net asset value of the funds, and that, in turn, will change the investor’s desired mix. If the equity portion of the portfolio, for instance, increases from Rs 7 lakh to Rs 8.5 lakh, while the bond portion moves to Rs 1.5 lakh, the total equity exposure will be 85 per cent. This is clearly in excess of the investor’s desired equity exposure. Under such circumstances, the investor must cut equity in the portfolio by Rs 1.5 lakh to maintain the ideal mix.

Once you get started, it’s not a difficult thing to follow. But the best part is that you will, by default, add equity to your portfolio when the times are bad and, thus, buy stocks at cheap prices, and book profits when the times are good.