Balancing act

Shifts in the equity and debt markets have automatically changed your asset allocation. We tell you what to do.

By Tejas Bhope        Print Edition: May 3, 2007

The stage of your life and state of markets (equity and debt) decide where you invest and how much. Change in either means you review and reallocate assets in your portfolio. A lot has changed in the stock market in the past few weeks, as has in the debt market—with interest rates on a seemingly unstoppable rise.

The stage of your life and state of markets (equity and debt) decide where you invest and how much. Change in either means you review and reallocate assets in your portfolio. A lot has changed in the stock market in the past few weeks, as has in the debt market—with interest rates on a seemingly unstoppable rise.

A rule of thumb suggests that the debt proportion of your financial asset allocation should be equivalent to your age. For example, a 25-year-old should have 25% invested in debt. The rest should be in growth assets such as equity. Of course, there should be a certain amount (maybe 10%) kept in liquid assets to manage emergencies.

As markets swing, the asset allocation automatically changes, prompting the need to rebalance.

For example, Parth Dalal, 33, a private sector bank employee, has toned down his aggressive profile as his life situation changed. Says Dalal: “I used to invest nearly 100% in equities. I am now a father and feel the need to secure my kid’s future.” So he’s reduced his equity allocation to 70%, redeeming 30% of his equity and invested that in a liquid fund. Dalal plans to pare equity exposure as he grows older.

Critically, movements in the equity markets may lead to big changes in asset allocation. Consultant Sunil Rajashekar, 30, made an initial allocation of 40% to equities in 2004. Since then equity markets have soared and the value of Rajashekar’s equity portfolio has bloated to about 70% of his assets.

Critically, movements in the equity markets may lead to big changes in asset allocation. Consultant Sunil Rajashekar, 30, made an initial allocation of 40% to equities in 2004. Since then equity markets have soared and the value of Rajashekar’s equity portfolio has bloated to about 70% of his assets.

Rajashekar says: “Although I have made money, I am not comfortable with that kind of exposure to equities. I have some foreseeable liabilities. I will bring my equity exposure back to 40%.” He must now rebalance if he wishes to revert to the original allocation ratios.

Let’s examine the options for Rajashekar (see flow chart on the following page). Three years ago, he invested Rs 40,000 in equities and Rs 60,000 in debt funds. So, the asset allocation was equity: 40%, and debt: 60%.

The bull market has earned him total returns of about 300% on equity, while the debt appreciated by about 19%. The total value of his portfolio today is Rs 2.23 lakh, of which Rs 1.6 lakh is equity and Rs 71,460 is debt. His allocation is now 72% equity and 28% debt.

There are three ways to revert to the original proportions. One is to book profits of Rs 1.12 lakh in equity which wil reduce it’s share back to the 40% level.

That cash can then be used to payoff liabilities or consumed. The proportionate holdings revert to the original position. The total portfolio value will stand at about Rs 1.19 lakh. This method does get back to the desired proportion but it also reduces total asset value. There may be tax liabilities or exit loads payable (in case of equity mutual funds being liquidated). You must also decide what to do with the cash released in this process.

The third option: If you don’t have adequate resources and don’t need cash right now, you may choose to just sell some equity and plough the proceeds back into debt. For example, in this case, Rajashekar could redeem 30% of his equity—Rs 69,000 approximately— and reinvest it in debt. This would take the allocation back to 40:60 while the portfolio size remains the same. However in this case too, he may need to pay exit or entry loads and taxes, if any.

The hidden advantage in taking this option is that you are booking profits in over-performing sectors and increasing allocation to undervalued categories. This means you will tend to buy low, and sell high in implementing this strategy.

Note that it is not rebalancing if you are changing your asset mix (by investing more in equity and cutting back debt) just because you anticipate a future stock market boom. In that case, you are changing your risk profile instead by getting more aggressive. Perhaps, you should resist the temptation of trying to time markets. Rebalancing is not about timing markets; it should be driven only by changes in life situations or by changed asset allocation ratios that cause discomfort.

Once you have drawn up an asset-allocation strategy, which suits you, you must maintain and review the percentage share of each asset. At regular intervals, you must recalculate the proportions and compare with the original. If there are changes that don’t suit your risk profile, then it’s time to rebalance the portfolio.

You can choose variations of any of the three methods outlined. It depends on your cash requirements. Rebalancing can also be taken to extremes and micro-managed. You might choose to rebalance on tactical asset allocation. That is, you may classify equity into large, small and mid-cap and debt into long and short timeframes.

Amar Pandit, financial planner of Myfinad advises regular rebalancing to weed out non-performers and to focus on goal-based asset allocation. Pandit says: “Apart from major re-jigging to adjust to change in life situations and market action, we review our clients’ portfolio once every six months. To ensure growth, it is essential to get out of non-performing stocks and funds to consistent performers. Rebalancing is also required when a client has invested for a particular goal. If you have set aside a corpus for your own or your child’s marriage, it is necessary to rebalance when it has grown to the desired size or, as the event draws nearer.”

Rebalancing helps maintain original asset allocation and imposes long-term discipline. It may protect you from downturns. Consider what happened to investors during the stock market carnage in May 2006. Investors let their equity exposure bloat out of proportion. When the markets crashed, they lost between 30% and 50% of those disproportionate equity holdings. If they had rebalanced, they would have automatically booked profits.

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