I was recently asked the titular question at an event. The person has a target asset allocation of 20% international equity, 40% Indian equity, and 40% fixed income (the international equity allocation is 33.3% of the overall equity allocation). He wants to know how to rebalance and manage this portfolio in future.
First of all, we must congratulate that person for thinking along the right lines. Very few investors appreciate the importance of rebalancing, which is simply resetting the actual asset allocation to the target allocation as it shifts with market movements.
This reduces overall portfolio volatility and keeps growth close to the expected path toward the target corpus (goal-based portfolio management).
So, how do we rebalance the above portfolio?
Review your portfolio once a year. We rebalance (sell one component and buy another) only if the deviation from the target asset allocation exceeds 5%. This is unlikely to happen year on year. So you do not have to rebalance and pay tax each year.
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You can further reduce rebalancing frequency by adjusting your monthly investments to accommodate small changes in portfolio weights. Manual investing without setting up SIPs makes this easier.
Please note: Some investors argue that they will not rebalance by buying/selling and would only adjust future inflows. This may work for small portfolio sizes and small deviations in asset allocations. Once the portfolio grows or if there is a huge rally or crash, proper rebalancing is essential. Otherwise, portfolio returns would rely on market forces and luck. We need to respect our money better. See: Can I rebalance my portfolio by adjusting my SIP amounts?
As the portfolio grows, these adjustments take longer and longer to reset the asset allocation. Markets can crash during that period, causing losses. See: Fearing tax, I didn’t rebalance my portfolio in Sep 2021 and now suffered higher losses!
Adjusting monthly investment amounts can handle small deviations. If done regularly, it can marginally reduce the amount we need to sell during a rebalance.
Let us consider some examples.
(1) Fixed income 36%, Indian equity 42%, International equity 22%
- Overall equity change is 4%
- Internal equity change is only 2%
You have two choices: (a) do nothing or (b) increase fixed income investments by a small amount.
(2) Fixed income 51%, Indian equity 24%, International equity 25%
- Sell fixed income (11% of total portfolio value)
- Sell International Equity (5% of the total portfolio value)
- Buy Indian Equity (16% of the total portfolio value)
OR
- Sell fixed income (11% of total portfolio value) and buy Indian equity
(3) Fixed income 41%, Indian equity 24%, International equity 35%
- No action necessary for fixed income. Sell International Equity (15% of the total portfolio value) and buy Indian equity
OR if you are too worried about taxes and exit loads
- No action necessary for fixed income. Sell international equity (10% of the total portfolio value) and buy Indian equity. That is, you are rebalancing to the edge of your 5% tolerance threshold
(4) Fixed income 52%, Indian equity 33%, International equity 15%
- Sell fixed income (12% of total portfolio value)
- Buy Indian Equity (7% of the total portfolio value)
- Buy International Equity (5% of the total portfolio value)
(5) Fixed income 40%, Indian equity 48%, International equity 12%
- Fixed income: No action.
- Sell Indian Equity (8% of the total portfolio value) and buy International Equity
(6) Fixed income 38%, Indian equity 41%, International equity 21%
- No action
OR
- Invest more in fixed income
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