Do I need to rebalance my portfolio even if I use index funds?

Published: December 7, 2021 at 7:00 am

In response to our FAQ on index investing, a viewer on our YouTube channel asks, “I am doing sip for the past one year in nifty50 and nifty next 50. Is frequent(once in a year) rebalancing necessary even for passively managed funds?”

While index funds remove the need for frequent fund performance review, they cannot magically remove other aspects of portfolio management. There is no “passive” button for risk management. It also has to be in active mode.

Steps to manage your portfolio

  1. Be clear about why you are investing. It has to be a lot more specific than “long-term wealth creation”!
  2. Be clear about when you need the money. Without this, all else fails.
  3. Do not mistake using equity or equity mutual funds for short-term goals. We recommend that new investors only use equity index funds for goals more than ten years away.  Mutual fund AMCs would recommend equity funds for goals more than three years away, but we cannot afford to take them seriously. The shorter the duration in equity investing, the more the outcome depends on luck since we will not have time to recover from a loss or remove gains.
  4. Even for long-term goals, do not go overboard on equity. We recommend only 50% to 60% equity, even for goals 25-30 years away. Higher equity allocation only increases the risk and the need to maintain it, not the “potential” to make more returns.
  5. Only at this stage does one consider the instruments to choose: active funds or passive funds? Direct equity or mutual funds or both? What kind of debt products to invest etc.
  6. While the above allocation is good enough to get started, investors should start thinking seriously about how they will reduce this equity allocation in the future. For example, I am 30 and wish to retire by 50; how should I plan my investments? Without this step, the fate of your hard-earned money would depend on luck. We need to respect money better than that. Once this plan is in place, we need to check if we are investing enough to account for this reduction in equity.
  7. We need to review our investments at the portfolio level and not at the instrument level. How much did my portfolio gain from one year to the next? If it fell, how much lower did it fall compared to equity? Are my overall equity and debt returns in line with my expectations? Where is my portfolio today in terms of the target corpus growth? Is any course correction required?
  8. If the asset allocation is off by more than 5%, we recommend a rebalance. For example, if you start with 50% equity and 50% fixed income, and after a year, the asset allocation is 52% equity and 48% fixed income, nothing needs to be done. After one more year, if it becomes 56% equity and 44% fixed income, a reset or a rebalance to 50:50 is recommended.
  9. All investors need to do is rebalance systematically (once a year) between equity and debt. There is no need for an additional rebalance bet Nifty and Nifty Next 50. See: Should I rebalance between Nifty and Nifty Next 50 systematically?

All the above steps are independent of where you invest – stocks or active funds, or passive funds. The worst mistake with equity is to blindly invest and assume that we will get returns over the long term. Both investing and risk management must be systematic to reach our target corpus.

If you like to start investing the right way, consider starting with this free seminar: Basics of portfolio construction: A guide for beginners.

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